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SOUTHERN  BRANCH, 

UNIVERSITY  OF  CALIFORNIA, 

LIBRARY, 

(LOS  ANGELES.  C/M-ir, 


THE  DEVELOPMENT  OF 
FEDERAL  RESERVE  POLICY 


THE  DEVELOPMENT 
OF  FEDERAL  RESERVE 

POLICY 


BY 
HAROLD  L.  REED 


PROFESSOR  OF  BANKING  AND  FINANCE,  WASHINGTON  UNIVERSITY 
SAINT  LOUIS 


BOSTON  AND  NEW  YORK 

HOUGHTON  MIFFLIN  COMPANY 

tlCfjc  i^ibcrsibc  l^reee  Cambvibqt 

1922 


5  8  y  i)  5 


COPYRIGHT,   1922,  BY  HAROLD  L.   REED 
ALL  RIGHTS  RESERVED 


CAMBRIDGE  •  MASSACHUSETTS 
PRINTED  IN  THE  U.S.A. 


i 


PREFACE 


Owing  to  the  unusual  character  of  the  period  during 
which  its  poHcy  has  been  developed,  many  misconceptions 
have  become  current  regarding  the  nature  and  purpose  of 
the  Federal  Reserve  banking  system.   Some  of  these  mis- 
K  conceptions  are  so  far-reaching  as  to  create  serious  dif- 
^   faculties  for  its  management.   No  central  banking  system 
^^  can  be  administered  efficiently  in  an  atmosphere  of  preju- 
dice and  misunderstanding.    The  business  public,  in  its 
appraisal  of  the  system's  management,  must  be  led  to 
apply  the  tests  of  sound  principles  of  economics  and 
^     finance  rather  than  those  merely  of  immediate,  individual 
r^    advantage.    It,  accordingly,  has  been   the  writer's  en- 
deavor to  do  what  little  his  capacities  permit  to  stimu- 
late a  proper  spirit  of  inquiry  regarding  Federal  Reserve 
\    matters. 
'i        It  has  appeared  to  the  writer  that  a  careful  examina- 
^    tion  of  the  development  of  the  reserve  system  could  be 
1    made  most  opportunely  by  one  not  connected  with  its 
^    management.    As  a  minor  spur  to  the  writer's  efforts 
there  has  been  the  belief  that  no  study  offers  superior  op- 
portunities for  investigating  the  working  of  the  principles 
of  money  and  credit  under  contemporary  conditions  of 
business  and  industry.    While  the  book  was  written  for 
the  general  reading  public,  rather  than  for  classroom 
purposes,  it  may  serve  as  a  second  book  to  follow  the 
reading  of  one  of  the  elementary  texts  in  college  courses 
in  Money  and  Banking. 

On  this  occasion  the  writer  would  like  to  express  his 


vi  PREFACE 

gratitude  to  those  who  have  helped  him  to  sustain  his  in- 
terest in  finance  and  economics.  Among  these  he  would 
like  to  mention  the  names  of  Professor  Kemmerer,  of 
Princeton  University;  Professor  Davenport,  of  Cornell 
University;  Dean  Joseph  French  Johnson,  of  New  York 
University;  Dean  Turner,  of  New  York  University; 
Dean  Gephart,  of  Washington  University,  now  Vice- 
President  of  the  First  National  Bank  of  St.  Louis;  Pro- 
fessor Willcox,  of  Cornell  University;  and  Professor  A.  S. 
Johnson,  at  present  a  member  of  the  editorial  staff  of  the 
New  Republic.  Professor  Allyn  A.  Young,  of  Harvard 
University,  has  been  a  constant  source  of  inspiration. 
April  30,  1922. 


CONTENTS 

I.  The  Working  of  the  Regional  System  i 

II.  Check  Collections  and  Clearances  under  the 
Federal  Reserve  20 

III.  State  Bank  Membership  in  the  Federal  Re- 
serve 50 

IV.  Advances  of  Reserve  Banks  —  Rediscounts        70 

V.  Direct    Collateral   Advances    to   Member 

Banks  97 

VI.  The  Development  of  the  Trade  Acceptance      105 

VII.  Agricultural  Credit  under  the  Federal  Re- 
serve 128 

VIII.  The  Development  of  the  Bank  Acceptance         154 

IX.  The    Open-Market    Operations    of    Reserve 
Banks  185 

X.  Advances  of  Reserve  Banks  —  Note  Issues       205 

XI.  Advances  of  Reserve  Banks  —  Deposits  and 
Reserves  221 

XII.  Federal  Reserve   Development,   November, 

1914,  TO  December,  1916  239 

Early  Problems  of  Organization 

XIII.  Federal  Reserve  Development,  January,  191 7, 

\     TO  April,  1917  261 

Financial  Preparation  for  War 

XIV.  Federal  Reserve  Development,  May,  1917,  to 
November  ii,  1918  267 
War-Time  Credit  Expansion 


viii .  CONTENTS 

XV.  Federal  Reserve  Development,  November  12, 

1918,  TO  May,  1920  292 

The  Period  of  Post- War  Credit  Expansion 

XVI.  Federal  Reserve  Development,  May,  1920,  to 

the  Present  Time  316 

The  Period  of  Business  Readjustment 

Index  345 


THE  DEVELOPMENT  OF 
FEDERAL  RESERVE  POLICY 


THE  DEVELOPMENT  OF 
FEDERAL  RESERVE  POLICY 


CHAPTER  I 

THE  WORKING  OF  THE  REGIONAL  SYSTEM 

In  the  matter  of  structure,  organization,  and  administra- 
tion, the  most  characteristic  feature  of  the  Federal  Reserve 
banking  plan  is  the  system  of  district  reserve  banks.  The 
regional  system  was  also  the  most  surprising  outcome  of 
the  legislative  planning  which  preceded  the  framing  of  the 
final  provisions  of  the  act.  Since  1907  the  question  of 
banking  reform  had  revolved  about  the  idea  of  establish- 
ing, for  the  entire  country,  a  single  large  and  powerful 
institution  which  should  hold  a  portion  of  the  reserves  of 
the  member  institutions  and  whose  advances  should  be 
controlled  by  a  single  board  or  directorate.  It  was  felt  by 
many  that  a  banking  organization  more  centralized  in  con- 
trol and  resources  offered  far  greater  possibilities  of  avoid- 
ing credit  collapses  than  our  old  decentralized  system. 
Demands  for  banking  reform  were  thus  predicated  upon  a 
belief  in  the  desirability  of  a  single  central  bank.  While  it 
was  anticipated  that  such  a  bank  must  establish  local 
branches  or  agencies,  it  was  not  expected  generally  that 
there  would  be  established  in  each  of  a  dozen  different  dis- 
tricts a  bankers'  bank  which  should  deal  for  the  most  part 
only  with  the  banks  of  its  own  territory.  It  was  not  antici- 
pated that  a  group  of  independently  operating  bankers' 
banks  would  be  set  up,  with  no  one  bank  possessing  domi- 


2  FEDERAL  RESERVE  POLICY 

nating  authority.  It  was  not  prcxHctcd  that  the  board 
with  general  control  would  not  be  allied  to  any  one  bank 
in  particular. 

The  motives  influencing  the  legislators  to  this  generally 
unf  ore  told  conclusion  are  now  well  known.  Despite  the 
admittedly  great  possibilities  of  a  central  bank,  there  were 
many  fears  that  such  an  institution  would  employ  its 
resources  with  partiality.  Recollections  of  the  old  preju- 
dices against  such  an  institution  surviving  from  the  time 
of  Andrew  Jackson  made  it  appear  the  part  of  political 
wisdom  to  the  Congressional  leaders  of  both  parties  to 
soften  the  emphasis  upon  the  idea  of  control  by  the  direc- 
torate of  one  all-powerful  institution.  In  the  Aldrich  Bill 
the  plan  which  might  be  said  to  represent  the  Republican 
attempt  to  secure  banking  reform,  the  idea  of  cooperation 
and  not  of  control  was  to  be  suggested  by  the  name  of  the 
new  system.  It  was  to  bear  the  name,  not  of  a  bank,  but 
rather  of  the  National  Reserve  Association.  Furthermore, 
its  machinery  was  to  be  such  as  not  to  exert  any  large 
measure  of  continuous  control.  By  the  issue  of  notes 
carrying  a  progressively  increasing  tax,  it  was  designed 
primarily  to  offer  relief  in  periods  of  emergency  and  threat- 
ened credit  collapse. 

The  underlying  theory  of  the  Federal  Reserve  system 
was  somewhat  different.  The  reserve  institutions  were  to 
bear  the  names  of  banks,  and  it  was  hoped  that  they  would 
operate  more  or  less  continuously.  But  lest  the  objections 
to  the  idea  of  a  central  bank  should  prove  too  strong, 
attacks  were  to  be  parried  in  another  way.  There  was  to 
be  no  single,  all-powerful  central  bank.  Twelve  regional 
banks,  distinct  in  membership  and  direction,  were  to  be 
set  up,  their  several  operations  to  be  harmonized  and 
coordinated  by  a  single  board.  The  Democratic  plan,  the 
Federal  Reserve  plan,  was  thus  based  upon  the  idea  of 


THE  WORKING  OF  THE  REGIONAL  SYSTEM       3 

preserving  for  the  banks  of  each  locality  as  much  control 
over  the  district  bankers'  bank  as  seemed  financially  expe- 
dient. Such  a  solution  was  indeed  typical  for  a  party 
whose  political  traditions  are  founded  so  largely  upon  the 
doctrine  of  States'  rights  and  local  autonomy. 

The  wisdom  of  the  regional  idea  was  attacked  strenu- 
ously by  many.  At  the  time  of  greatest  controversy, 
however,  the  ultimate  manner  of  the  operation  of  the 
Federal  Reserve  system  was  more  or  less  a  matter  of 
doubt.  There  was  no  experience  by  which  to  measure  the 
importance  of  the  numerous  objections.  But  now,  after 
nearly  a  decade  of  experience,  the  value  of  the  regional 
idea  can  be  appraised  more  accurately.  What,  then,  does 
past  operation  suggest  regarding  the  practicability  of  the 
plan?  An  inquiry,  such  as  this  projects,  renders  it  desir- 
able to  recall  some  of  the  earlier  points  upon  which  the 
regional  system  was  attacked.  An  advantage  of  restating 
these  objections  now  is  that  by  virtue  of  recent  experience 
the  haziness  which  beclouded  the  form  of  their  original 
statement  may  be  avoided,  in  part  at  least. 

In  the  first  place,  it  was  felt  that  the  regional  plan  would 
create  too  much  temptation  to  the  frequent  use  of  the 
reserve  bank's  resources.  The  basic  idea  was  to  bring  the 
bankers'  bank  more  close  to  the  member  institutions. 
Direction  was  so  planned  as  to  subject  its  management  to 
pressure  and  influence  exerted  by  the  member  banks  of 
the  locality.  Six  of  the  nine  district  directors  were  to  be 
chosen  by  the  member  banks.  Moreover,  the  regional  idea 
was  asserted  to  be  merely  a  substitute  for  the  plan  which 
contemplated  only  occasional  or  emergency  relief  for  the 
member  institutions.  It  was  evident  to  all  that  many 
dangers  must  lie  in  the  path  of  any  system  designed  to 
exercise  day-to-day  control  over  the  money  market.  To 
render  any  such  control  effective  the  advances  of  the  re- 


4  TEDERAL  RESERVE  POLICY 

serve  banks  must  be  large.  The  acceptance  of  'the  Euro- 
pean '  rule  of  procedure  —  keeping  the  central  bank's  rate 
above  the  market  —  might  leave  the  reserve  banks  a  piece 
of  unused  and  costly  machinery.  In  view'of  the  concentra- 
tion of  reserve  money  and  the  consequently  great  possi- 
bilities of  pyramiding  credits,  it  was  perceived  that  an 
unexampled  expansion  of  bank  advances  might  take  place. 
In  short,  the  regional  plan,  instead  of  guarding  against, 
seemed  actually  to  make  provision  for,  price  inflation. 

It  was  asserted,  furthermore,  that  the  regional  idea  was 
solely  a  compromise,  the  outgrowth  of  the  desire  to  avoid 
popular  objection.  Considerations  of  financial  wisdom 
were  held  to  have  been  subordinated  to  those  of  political 
expediency.  Few  have  been  the  occasions  when  compro- 
mise has  proved  successful  in  matters  financial,  and  it 
scarcely  could  be  hoped  that  banking  reform  would  con- 
stitute an  exception.  If  our  old  difficulties  were  due  prima- 
rily to  decentralization,  in  credit  control,  note  issues,  and 
reserve  holdings,  the  greatest  advantage  could  be  realized 
only  by  utilizing  to  the  utmost  the  idea  of  centralization. 
The  greatestdegree  of  benefit  could  be  obtained  only  by  es- 
tablishing a  single  bankers'  bank  dominating  the  member 
institutions  of  the  entire  country.  Any  other  solution 
must  perpetuate  among  the  reserve  banks  the  old  evil 
formerly  pertaining  to  the  individual  banks  —  scrambling 
for  reserves  in  periods  of  emergency  and  excessive  compe- 
tition in  the  period  of  business  activity.  To  be  sure, 
attempts  could  be  made  to  unify  the  operations  of  the 
reserve  banks  by  granting  certain  powers  of  control  to  the 
Federal  Reserve  Board.  But  this,  it  was  argued,  would  be 
merely  a  patchwork  device.  The  regional  system  must 
limit  somew^here  the  possibilities  of  centralized  control 

'  Only  in  a  very  general  sense  is  it  correct  to  imply  that  the  dominating  policy 
of  European  central  banks  has  been  to  keep  the  official  rate  above  the  market 
rate.  There  are,  of  course,  many  exceptions. 


THE  WORKING  OF  THE  REGIONAL  SYSTEM       5 

and  concerted  action.  Otherwise  what  would  be  its  advan- 
tage over  a  single  central  bank? 

Opponents  of  the  plan  argued  also  that  it  represented  an 
attempt  to  isolate  different  territories  of  finance,  to  estab- 
lish sectionalism  in  an  impossible  field.  Finance,  any  more 
than  trade,  cannot  be  confined  within  artificial  borders. 
The  call-rate  policy  of  the  metropolitan  bank  may  affect 
the  Southern  cotton  planter  in  as  real  (though  a  more  in- 
direct) a  manner  as  the  credit  policy  of  his  own  local  bank. 
Even  under  our  old  faulty  banking  system  many  were  the 
means  by  which  bank  capital  could  be  transferred  from 
one  locality  to  another.  The  call  rates  of  city  banks  must 
exert  some  influence  upon  the  place  of  investment  of  sur- 
plus bank  capital.  Our  various  banking  channels  cross 
somewhere,  even  if  in  a  haphazard  manner.  The  rivulets  of 
credit,  sluggish  though  they  be,  carry  eventually  their 
deposits  to  the  deeper  channels.  If  the  various  districts 
of  the  country  are  related  in  fact,  why  not  recognize  this 
relationship  in  the  structure  of  the  banking  system?  Fail- 
ure to  recognize  it  must  create  only  difificulty.  If  twelve 
different  open  markets  for  commercial  paper  exist,  wherein 
has  correction  been  found  for  the  old  evil  —  inability  to 
mobilize  efficiently  a  large  portion  of  our  surplus  bank 
reserves  at  the  point  of  greatest  need  ? 

These  were  some  of  the  more  earnestly  developed 
attacks  upon  the  regional  plan.  Let  us  next  consider  as 
completely  as  may  be  their  respective  merits.  In  doing 
this,  however,  an  attempt  must  be  made  to  avoid  for  the 
present  those  aspects  of  the  problem  which  involve  ultra- 
complicated  features  of  reserve  banking. 

In  the  light  of  recent  experience  much  justification  is 
afTorded  the  view  that  the  regional  system  is  peculiarly 
susceptible  to  undue  credit  expansion.  Local  pressure  for 
enlarged  credit  grants  is  always  most  intense.    Business 


6  FEDICRAL  RESERVE  POLICY 

thrives  on  easy  money;  rising  prices  usually  create  the 
situation  of  a  widening  margin  between  costs  of  produc- 
tion and  sale  proceeds.  Those  who  are  injured  by  price 
inflation,  those  whose  money  incomes  are  incapable  of 
quick  adjustment,  exert  only  feeble  pressure  upon  the 
banking  administration.  Wage-earners  scarcely  ever 
emphasize  this  cause  of  their  woes;  they  are  much  more 
prone  to  employ  the  devices  of  strikes  and  concerted 
action.  The  middle  class  has  no  influence  upon  the  bank- 
ing administration.  Occasionally  entrepreneurial  activity 
is  injured  by  the  rising  scale  of  prices,  as,  for  instance,  in 
the  public  utility  and  railroad  fields.  But  the  petitions  of 
industrial  entrepreneurs,  in  the  same  manner  as  those  of 
the  wage-earners,  are  scarcely  ever  addressed  to  the  bank- 
ing administration.  Prayers  for  higher  rates  offer  greater 
prospects  of  relief.  Because  of  the  nature  of  things,  it  is 
peculiarly  necessary  that  the  banking  structure  be  such  as 
to  make  easy  denial  of  demands  for  excessive  credits.  It  is 
necessary  that  banking  control  be  lodged  in  the  hands  of 
those  well  equipped  to  resist  the  credit  demands  of  those 
who  are  not  responsible  for  the  interests  of  all  classes  in 
society,  and  who  do  not  have  in  mind  merely  the  short- 
time  requirements  of  business. 

One  means  of  ensuring  conservatism  in  the  operations 
of  the  central  bank  is  to  emphasize  the  emergency  charac- 
ter of  the  institution.  Let  the  rates  on  the  advances  of  the 
central  institution  be  normally  above  the  market  rate. 
Advances  from  the  central  bank  are  thus  rendered  unprofit- 
able on  ordinary  occasions.  But  aid,  costly  though  it  be  to 
secure  it,  is  available  for  periods  of  credit  strain. 

It  has  been  stated  previously  that  the  regional  idea  is 
based  on  the  theory  of  continuous  control  of  the  money 
market.  It  necessitates  accordingly  constant  employment 
of  reserve  funds.   This,  in  turn,  imposes  the  necessity  of 


THE  WORKING  OF  THE  REGIONAL  SYSTEM       7 

keeping  the  rates  sufficiently  low  to  occasion  demand  for 
the  funds  of  the  reserve  system.  The  rule  of  remaining  out 
of  the  market  except  in  emergencies  is  not  so  easy  of 
acceptance  under  the  regional  system.  Control  by  member 
banks  is  too  direct.  And  so  far  as  the  particular  facts  of 
the  reserve  system  are  concerned,  the  regional  idea  was 
invoked  as  a  substitute  for  a  previous  plan  in  which  the 
emergency  character  of  the  institution  was  emphasized. 

It  may  be  that  in  the  course  of  time  a  means  may  be 
developed  whereby  the  volume  of  reserve  advances  may  be 
stabilized  in  relation  to  the  needs  of  trade  even  though  the 
reserve  banks  are  kept  continuously  in  the  market.  In  the 
opinion  of  the  writer,  however,  the  principles  for  regulating 
the  volume  of  reserve  advances  have  not  yet  been  formu- 
lated with  sufficient  definiteness.^ 

The  above  paragraphs  should  not  be  interpreted  as 
advocating  absolute  aloofness  from  the  market  except  in 
periods  of  strain.  Those  who  stress  the  emergency  charac- 
ter of  the  reserve  banks  would  admit  the  necessity  of  some 
measure  of  continuous  functioning.  But  such  operations 
need  not  be  so  extensive  in  volume.  It  was  asserted,  fur- 
thermore, that  if  the  share  contributions  of  member  banks 
to  the  capital  of  reserve  banks  could  be  returned,  there 
would  be  even  less  pressure  to  find  continuous  use  of 
reserve  bank  funds.  If  the  idea  of  emergency  advances 
only  were  developed,  could  not  the  reserve  institutions 
develop  enough  investment  power  without  share  capital 
contributions  from  member  banks?  Reserve  banks  would 
still  possess  the  resources  based  upon  their  holdings  of 
member  banks'  reserves.  But  further  discussion  of  this 
aspect  of  the  problem  can  best  be  postponed  till  a  later 
chapter.* 

'See  infra.  Chapter  XVI. 
*See  injra,  Cliapter  XII. 


8  FEDERAL  RESERVE  POLICY 

In  reply  to  the  second  objection,  that  the  regional  plan 
was  based  upon  the  idea  of  divorcing  various  banking 
channels,  it  was  replied  that  the  scheme  represented  no 
more  sectionalism  than  existed  in  fact.  Attention  was 
called  to  the  great  differences  in  banking  customs  and 
needs  of  the  various  districts  of  the  country.  It  was 
asserted  that  nowhere  in  the  world  was  there  an  illustra- 
tion of  a  central  bank  successfully  dominating  so  large  and 
diverse  a  banking  territory  as  that  of  continental  United 
States.   In  the  words  of  H.  P.  Willis : ' 

So  far  as  area  is  concerned,  then,  there  would  be  room  in  the 
United  States  for  a  number  of  institutions  corresponding  to  the 
total  number  of  central  banks  throughout  the  European  con- 
tinent. The  mere  fact  that  international  lines  divide  the  Bank 
of  France  from  the  Bank  of  England  or  the  Bank  of  Germany 
has  no  relationship  to  the  economics  of  the  situation.  It  is  a 
fact  that  no  such  extent  of  territory  as  the  United  States  is  dealt 
with  by  one  single  central  bank.  The  Federal  reserve  system, 
with  its  series  of  reserve-holding  institutions,  therefore,  does 
in  fact  correspond  much  more  nearly  to  European  practice  than 
would  a  single  central  institution  with  branches.  Each  Federal 
reserve  bank  includes  within  its  district  a  territory  which,  as 
the  nation  expands  and  its  business  increases,  will  rank  with 
the  territory  tributary  to  one  of  the  European  central  insti- 
tutions. 

From  the  point  of  view  of  directness  and  efficiency  in 
administration,  justification  for  Mr.  Willis's  remarks  is 
clear.  The  regional  character  of  the  system  has  eliminated, 
undoubtedly,  many  anticipated  difficulties  of  direction. 
But  has  this  been  accomplished  at  the  expense  of  destroy- 
ing all  possibilities  of  financial  cooperation  between  the 
various  reserve  banks?  Has  the  reserve  system  meant  the 
segregation  of  financial  territories  and  the  consequent  de- 
struction of  any  effective  means  of  establishing  a  country- 
wide market  for  commercial  paper  of  various  origin,  in 

'  Tlie  Federal  Reserve,  p.  128. 


THE  WORKING  OF  THE  REGIONAL  SYSTEM       9 

such  a  way  as  to  enable  the  surplus  funds  of  the  country  to 
be  mobilized  effectively?  IVIore  precisely,  have  the  reserve 
banks  shown  willingness  to  aid  each  other,  by  means  of  the 
rediscounting  or  direct  purchase  of  each  other's  paper? 

In  developing  this  inter-district  harmony  the  succession 
of  events  has  favored  the  administration.  In  the  early 
years  of  operation,  the  period  when  no  past  experience  in 
cooperation  was  possessed,  a  time  accordingly  when  at- 
tempts to  secure  mutual  aid  would  be  difficult,  there  was 
little  demand  for  this  sort  of  reserve  activity.  Due  to  the 
reduction  of  reserve  minima  under  the  terms  of  the  act  and 
to  the  importation  of  gold  from  abroad,  reserves  of  all  the 
district  banks  were  generally  high.  When  the  need  of 
inter-district  aid  did  develop,  the  Nation  was  engaged  in  a 
war  so  enveloping  as  to  render  apparent  to  all  the  neces- 
sity of  subordinating  considerations  purely  of  sectional 
advantage.  In  such  a  situation  it  was  easy  for  the  Board 
to  insist,  in  the  determination  of  the  inter-district  shifting 
of  funds,  upon  principles  which  ordinarily  might  have 
created  some  objection.  At  a  time  when  so  many  devices 
of  expansion  were  available,  concessions  by  one  bank 
would  not  necessarily  impair  its  own  lending  power. 
Accordingly,  as  a  guiding  principle,  reserves  were  to  be 
equalized  between  the  various  district  banks  regardless  of 
the  cause  of  any  bank's  need  for  aid. 

The  accompanying  table  on  page  10  indicates  thevolume 
of  such  inter-district  operations  during  some  of  the  years 
when  their  amount  was  exceedingly  heavy. 

Needless  to  remark,  operations  so  large  in  volume  have 
affected  greatly  the  reserve  positions  of  the  district  banks 
on  numerous  occasions,  increasing  the  reserves  of  some  and 
lowering  those  of  others.  Indicative  of  this  is  the  accom- 
panying table  on  page  11.* 

'See  Report  of  the  Federal  Reserve  Board  for  1919,  p.  8. 


10  FEDERAL  RESERVE  POLICY 

Inter-District  Movement  of  Discounted  and  Purchased  Paper' 


Bank 


For  the  Year  1918 


Excess 
Move- 
ment 
from' 


Excess 
Move- 
ment 


For  the  Year  1919 


Excess 

Move- 
ment 

FROM 


Excess 
Move- 
ment 


For  the  Year  1920 


Excess 

M  OV  E- 

ment 

FROM 


Excess 
Move- 
ment 


In  Thousands  of  Dollars  * 


Boston 

J5  92.046 

$    131.165 

$    986,280 

New  York 

329.491 

996,412 

S    764,219 

Philadelphia  .  . 

$  56,562 

826.521 

191.872 

Cleveland  .... 

207.534 

$    463,909 

1.120,832 

Richmond  .... 

68,732 

837.866 

699,675 

Atlanta 

77.722 

72.625 

250,510 

Chicago 

195,192 

1.583,864 

108,054 

St.  Louis 

679 

181,029 

302.249 

Minneapolis  .  . 

82.907 

536.513 

253.096 

Kansas  City  .  . 

27.564 

16,060 

386.137 

Dallas 

94,135 

337,398 

292.513 

San  Francisco . 

93.046 

420,612 

325,105 

Total 

$662,805 

$662,805 

$3,201,987 

$3,201,987 

$3,140,271 

$3,140,271 

'  The  following  extract  from  the  Federal  Reserve  Bulletin  for  October.  1920  (p.  1015),  is 
explanatory  of  the  relation  of  the  Gold  Settlement  Fund  to  the  inter-district  shifting  of 
funds: 

"Originally  established  for  the  purpose  of  expediting  the  settlement  of  balances  in  gold 
between  Federal  Reserve  Banks  arising  out  of  exchange  and  clearing  operations,  the  shift- 
ing of  funds  from  district  to  district  in  connection  with  rediscount  transactions  between 
Federal  Reserve  Banks  has  become  one  of  the  principal  services  of  the  fund  under  present 
conditions,  and  its  efficacy  has  been  strikingly  exemplified  during  the  heavy  credit  strain 
incident  to  the  financing  of  our  present  crops. 

"When  a  Federal  Reserve  Bank,  through  the  Federal  Reserve  Board,  has  been  granted 
an  extension  of  credit,  and  such  extension  has  been  allocated  t9  some  other  Federal  Reserve 
Bank,  the  extension  is  made  effective  through  the  transfer  of  title  to  gold  in  the  gold  settle- 
ment fund  at  Washington.  The  gold  settlement  fund  .  .  .  consists  of  deposits  of  gold 
which  have  been  made  by  the  Federal  Reserve  Banks  and  agents  with  the  Treasury,  which 
holds  them  in  trust.  .  .  .  The  gold  in  this  fund  is  seldom  physically  moved,  though  it 
frequently  changes  ownership,  transfer  of  ownership  being  effected  through  the  mechanism 
of  the  fund  without  the  need  of  moving.  Ownership  in  the  fund  being  represented  by  entries 
in  the  books  of  the  fund,  an  applicant  Federal  Reserve  Bank  which  has  been  granted  credit 
extension  receives  its  accommodation,  and  the  gold  to  which  it  is  entitled,  through  a  credit 
entry  in  the  gold  clearing  books  of  the  Federal  Reserve  Board.  Inasmuch  as  the  gold 
settlement  fund  is  a  part  of  the  gold  reserve  of  each  of  the  Federal  Reserve  Banks,  this 
transfer  amounts  to  shifting  a  given  volume  of  reserve  metal  from  a  granting  bank  to  the 
applicant  bank.  The  effect  is  to  transfer  a  corresponding  amount  of  credit-granting  or 
credit-lending  power  from  the  granting  institution  to  the  applicant.  The  latter  is  then  at 
liberty  to  use  it  as  it  may  see  fit  in  extending  further  accommodation  to  the  member  banks 
within  its  district. The  transaction  has,  in  short,  really  amounted  to  a  temporary  shifting 
of  banking  funds  from  one  district  to  another." 

'  By  this  operation  the  bank  gains  in  reserve  money.  It  is  given  credit  on  the  Gold  Settle- 
ment Fund.   See  note  '  for  description  of  the  working  of  this  fund. 

'  By  this  operation  the  bank  loses  in  reserve  money.  It  is  debited  on  the  Gold  Settlement 
Fund.   Sea  note  '  for  description  of  the  working  of  this  fund. 

•  Figures  are  compiled  from  the  yearly  Reports  of  the  Federal  Reserve  Board. 


THE  WORKING  OF  THE  REGIONAL  SYSTEM      ii 

Ratio  of  Total  Reserves  to  Combined  Net  Deposit  and  Federal 
Reserve  Note  Liauilities,  December  26,  1919 


Bank 

Actual 

After  Adjustment  of  Reserves  by  Deducting 
A.MOUNT   OF   Bills   Rediscounted   with    or 
Sold  to  Other  Federal  Reserve  Banks  and 
Adding  Amount  of  Bills  Discounted  for  or 
Purchased  from  Other  Federal  Reserve 
Ba.nks 

Boston 

New  York 

44.0 
40.0 
40.8 

46.3 
40.9 
52.8 
50.6 
46.5 
39.4 
43-1 
49-4 
54-9 

243 
36.2 

Philadelphia 

Cleveland 

32.7 
49-4 
43-5 
55.2 

Richmond 

Atlanta 

Chicago 

58.8 

St.  Louis 

60.5 

Minneapolis 

Kansas  City 

Dallas 

39-4 
41-3 

77.0 

San  Francisco 

59-3 

For  all  banks 

44.8 

44.8 

The  amount  of  inter-district  lending  of  funds  has  thus 
been  great.  But  to  what  factors  shall  we  ascribe  the  will- 
ingness of  the  various  banks  to  cooperate  in  this  way? 
Has  it  been  due  to  the  unusual  circumstances  of  the  period 
when  operations  of  this  sort  were  the  greatest?  Has  it  been 
merely  an  aspect  of  the  problems  of  war  and  post-war 
finance?  Or  has  it  been  the  desire  of  the  lending  bank  to 
establish  a  basis  for  its  own  pleas  for  aid  when  it  itself 
should  become  the  needy  institution?  Answers  to  such 
queries  as  these  should  throw  some  light  upon  the  prob- 
able future  amount  of  inter-district  operations. 

Some  explanation  of  the  preceding  problems  is  afforded 
by  the  following  sentence  from  the  Federal  Reserve  Bulletin 
for  October  i,  1920:' 

The  process  of  shifting  bank  resources  through  inter-reserve 
rediscounting  was  necessarily  called  into  play  and  has  become 
a  regular  and  important  feature  of  the  working  of  the  Federal 
Reserve  System. 

•  Page  1014. 


12  FEDERAL  RESERVE  POLICY 

As  to  how  this  function  of  the  reserve  has  developed,  it 
will  be  recalled  that  in  the  earlier  years  under  the  reserve 
system  the  effectiveness  of  the  machinery  for  transferring 
funds  from  district  to  district  was  not  fully  tested.  The 
release  of  reserves  on  the  inauguration  of  the  reserve  sys- 
tem and  the  inflow  of  gold  from  abroad  in  the  following 
years  made  unnecessary  the  use  of  reserve  funds  to  any 
appreciable  extent.  But  after  the  period  of  rising  prices 
during  the  war  and  the  getting  more  completely  into  the 
market  of  the  Federal  Reserve,  inter-district  aid  became 
necessary  on  the  part  of  the  district  subjected  to  unusual 
crop-moving  or  seasonal  demands.  Since,  however,  the 
peak  of  money  demand  is  not  reached  simultaneously  in 
all  districts,  it  is  possible  for  the  Reserve  Board  to  offset 
the  seasonable  fluctuations  and  changes  in  demand  against 
one  another.  In  this  way  the  strain  previously  thrown 
upon  the  city  banks  in  the  financial  centers  by  the  calls 
from  the  interior  becomes  merely  a  transfer  of  surplus 
reserve  funds  from  one  district  to  another. 

Various  are  the  circumstances  which  determine  the 
extent  to  which  any  one  district  bank  may  require  such 
aid.  Industries  dependent  largely  upon  agriculture  must 
experience  usually  greater  seasonal  fluctuations  in  the 
demand  for  bank  capital  than  those  more  largely  manu- 
facturing. Districts  covering  a  territory  diversified  in 
climate  and  in  the  nature  of  their  industries  may  be  able 
more  easily  to  finance  exceptional  demands  in  one  part  by 
reliance  upon  surplus  funds  in  another  without  drawing 
heavily  upon  other  districts.  A  section  thus  diversified  is 
Number  12,  the  Pacific  Coast  Section,  including  States 
from  the  Canadian  border  to  the  boundary  line  of  Mexico. 

By  relying  upon  the  principle  of  reciprocity  in  the  meet- 
ing of  their  mutual  seasonal  and  emergency  demands.  It 
may  be  possible  to  avoid  to  some  extent  the  objection  of 


THE  WORKING  OF  THE  REGIONAL  SYSTEM      13 

sectional  financial  isolation.  It  is  true  that  the  regional 
system  creates  some  obstruction  to  the  free  flow  of  funds 
from  district  to  district.  Some  friction  will  be  encountered 
always  in  mobilizing  effectively  free  bank  funds.  But  this 
difficulty  can  be  mitigated  greatly  and  is  perhaps  justified 
by  the  administrative  efficiency  and  political  advantage  of 
the  regional  plan. 

One  difficulty  remains,  however.  If  inter-district  shift- 
ing of  funds  is  regularly  contemplated,  wherein  lies  the 
advantage  of  the  regional  system  in  meeting  objections 
emphasizing  possibilities  of  sectional  discrimination? 
Rediscounts  by  one  reserve  bank  for  another  can  be 
required  by  the  Federal  Reserve  Board.  According  to  the 
liberality  with  which  it  treats  one  district,  and  the  con- 
servatism another,  the  display  of  sectional  partiality  is 
easily  possible.  If  exercised,  its  results  would  be  identical 
with  the  more  direct  partiality  displayed  by  the  director- 
ate of  a  single  central  bank. 

In  the  opinion  of  the  writer,  however,  partiality  in 
requiring  reserve  banks  to  render  inter-district  aid  is  not 
nearly  so  probable.  Under  the  reserve  system  it  will  be 
expected  that  the  borrowing  districts  in  normal  years  shall 
not  merely  clear  their  books  in  the  off  season,  but  also 
shall  be  able  to  render  aid  to  other  districts  in  the  slack 
season.  In  the  long  run  the  advances  to  member  banks  in 
any  one  district  must  bear  some  relation  to  the  resources 
of  the  reserve  bank,  resources  which  represented  originally 
the  contributions  of  the  members.  Under  a  single  bankers' 
bank  the  determination  of  the  legitimate  amount  of 
advances  to  any  one  locality  must  be  based  on  more  hypo- 
thetical grounds.  Failure  to  map  out  definite  and  per- 
manent districts  would  create  much  more  difficulty  in 
determining  the  relative  merits  of  the  demands  of  the 
various  sections  of  the  country.    Under  the  present  sys- 


14  FEDERAL  RESERVE  POLICY 

tpm  the  resources  of  each  reserve  bank  are  real  and  the 
advances  to  anyone  section  do  not  depend  so  largely  upon 
the  rulings  of  a  single  directorate. 

A  query,  of  possibly  greater  in^portance,  relating  to  the 
political  expediency  of  the  regional  plan,  necessitates  some 
concluding  discussion.  How  effective  has  been  the  regional 
plan  in  enabling  the  general  administrative  body  —  the 
Federal  Reserve  Board  —  to  confine  complaints  to  the 
district  in  which  the  discontent  has  arisen?  To  what 
extent  has  the  Board  been  able  to  disclaim  responsibility 
for  policies  initiated  by  the  district  directorate?  In  what 
measure  has  each  district  been  held  responsible  by  the 
public  for  conditions  logically  the  result  of  its  own  poli- 
cies? Very  important  is  the  answer  to  this  query  because 
the  system  is  much  more  likely  to  be  modified  by  legis- 
lative action  when  complaints  are  directed  against  the 
central  administrative  body  than  when  directed  merely 
against  one  of  the  twelve  administrative  subdivisions. 

It  must  be  admitted  at  the  outset  that  there  has  been  a 
persistent  refusal  by  the  general  public  to  recognize  the 
regional  character  of  the  system.  In  the  period  of  agricul- 
tural depression  following  the  spring  of  1920,  nothing  was 
more  clear  than  this.  Newspapers  and  journals  of  the 
Middle  West  and  South  wrote  many  an  editorial  and  pub- 
lished many  a  cartoon  to  establish  the  partiality  of  the 
Federal  Reserve  Board  toward  the  metropolitan  financial 
interests.  In  virtually  all  of  these  the  existence  of  different 
reserve  banks  in  the  various  sections  of  the  country  was 
ignored .  ' '  The  men  who  grew  the  wheat "  could  not  obtain 
credit  to  hold  their  crops  for  a  fair  price,  whereas  the  "men 
who  tried  to  corner  the  wheat  market,"  it  was  asserted, 
were  bountifully  supplied  with  funds  emanating  from  the 
Federal  Reserv^e.  No  attention  at  all  was  ordinarily  paid 
to  the  fact  that  the  National  City  Bank  of  New  York  is 


THE  WORKING  OF  THE  REGIONAL  SYSTEM      15 

served  by  the  New  York  Reserve  Bank;  whereas  the  First 
National  Bank  of  Waycross,  Georgia,  is  served  by  the 
Atlanta  Reserve  Bank.' 

Indicative  further  of  this  point  of  view,  there  is  even  to 
be  found  an  address  of  the  former  Comptroller  of  the  Cur- 
rency, and  ex-officio  member  of  the  Federal  Reserve 
Board,  Mr.  John  Skelton  Williams,  delivered  in  Augusta, 
Georgia,  July  14,  1921.''  The  following  extract  may  be 
quoted  from  this  address: 

While  small  banks  in  the  farming  districts  were  being  taxed 
in  this  manner,  great  banks  in  New  York  were  being  supplied 
with  practically  unlimited  amounts  of  money  at  5,  6,  and  7 
per  cent.  The  official  record  will  show  that  while  the  Reserve 
Bank  collected  $2100  (equal  to  8  per  cent  on  the  bank's  entire 
capital  stock  for  12  months)  from  a  little  bank  in  your  adjoining 
State  of  Alabama,  for  the  use  of  about  $112,000  for  two  weeks 
in  crop-moving  time,  a  year  ago,  a  big  bank  in  New  York, 
whose  funds  were  largely  employed  in  speculative  operations 
and  deals,  for  the  same  cash  consideration,  or,  say,  $2100,  was 
given  the  use  of  about  $800,000  for  the  same  time. 

And  in  his  charges  of  wasteful  and  uneconomical  expendi- 
tures before  the  Atlanta  audience  the  bulk  of  the  illustra- 
tions were  drawn  from  the  experience  of  the  New  York 
bank.  The  financial  layman  could  easily  gain  the  impres- 
sion that  the  Federal  Reserve  Board  was  a  bank  with  its 
main  office  in  New  York  City. 

In  view  of  such  assertions  as  these  by  a  former  member 
of  the  general  administrative  body,  it  is  not  at  all  surpris- 
ing that  a  large  portion  of  the  lay  public  has  been  induced 
easily  to  convict  the  Board  of  sectional  partiality,  even 

•  It  is  indisputable  that  reserve  funds  found  their  way  in  large  amounts  in  the 
post-war  period  to  the  speculative  markets.  But  in  the  opinion  of  the  writer 
this  was  an  inevitable,  though  unintended  result  of  the  "easy-money  policy" 
of  the  financial  administration  in  the  war  and  post-war  ix.'riod.  This  aspect 
of  the  problem  will  be  discussed  in  later  chapters. 

'  This  address  is  published  in  the  Commercial  and  Financial  Chronicle,  July  23, 
192 1,  pp. 354-58. 


i6  FEDERAL  RESERVE  POLICY 

though  its  regulations  have  been  general  and  scarcely  ever 
possessed  merely  a  sectional  application. 

Despite  repeated  assertions  regarding  the  limitation  of 
its  own  powers  to  points  of  general  policy,  the  Federal 
Reserve  Board  has  found  it  exceedingly  difficult  to  define 
the  sphere  of  regional  responsibility.  Attempts  to  estab- 
lish the  accountability  of  the  district  directorate  for  its 
own  specific  acts  have  always  occasioned  severely  adverse 
criticism.  Indeed  one  of  the  legislators,  possibly  more 
responsible  for  the  final  form  of  the  Reserve  Act  than  any 
other  one  man.  Senator  Owen,  complained  on  one  occasion 
most  bitterly  '  that  the  Board's  policy  meant  the  abdica- 
tion of  its  powers.   Thus : 

The  Federal  Reserve  Board  was  created  to  control,  regulate, 
and  stabilize  credit  in  the  interest  of  all  the  people.  .  .  .  [It]  is 
the  most  gigantic  financial  power  in  all  the  world.  .  .  .  Instead 
of  using  this  great  power  as  the  Federal  Reserve  Act  intended 
that  it  should  be  used,  the  Board  abdicated.  Instead  of  using 
this  power  in  the  interests  of  all  the  people,  the  bankers  in- 
cluded, it  delegated  this  power  to  the  bankers.' 

As  long  as  the  act  entrusts  to  the  Board  such  general 
powers  as  supervision  of  rediscount  rates;  since  decisions 
in  such  matters  must  always  afTect  some  districts  more 
vitally  than  others,  it  will  prove  most  difficult  to  place 
upon  the  shoulders  of  the  district  directorate  any  large 
measure  of  responsibility  for  what  is  believed  to  be  the 
industrial  and  business  results  of  its  general  credit  policy. 
No  matter  how  refined  the  game  of  "passing  the  buck," 
success  stands  to  be  won  by  the  body  most  frequently  in 
contact  with  the  public.  The  local  banker,  in  denying 
credit  accommodations  lays  responsibility  upon  the  dis- 
trict directorate;  the  district  board  calls  attention  to  the 
w^arnings  of  the  Board  against  the  granting  of  "unessen- 

'  Cf .  Commercial  and  Financial  Chronicle,  July  30,  192 1 ,  p.  475. 
*Six  of  the  nine  district  directors  are  selected  by  the  member  banks. 


THE  WORKING  OF  THE  REGIONAL  SYSTEM      17 

tial  credits."  The  Board,  however,  can  find  no  body 
higher  up,  unless  it  be  the  legislators  responsible  for  the 
terms  of  the  statute. 

Nevertheless,  the  writer  believes  that  the  regional  plan 
has  many  merits  of  political  expediency.  The  reserv^e  sys- 
tem is  new,  and  much  educational  work  still  remains  to  be 
done  in  acquainting  the  public  with  the  nature  of  its 
organization  and  operations.  Because  of  the  exceptionally 
abnormal  period  during  which  it  has  lived,  it  has  been 
impossible  for  the  Board  to  develop  a  permanent  principle 
regulating  reserve  bank  advances. 

Furthermore,  the  responsibility  of  the  district  director- 
ate has  undoubtedly  rendered  it  easier  on  many  occasions 
for  the  Board  to  resist  the  directly  expressed  demands  of 
certain  special  interests  for  credit  advances.  It  has  enabled 
the  Board  to  insist  that  it  itself  was  not  a  bank  and  had  no 
money  to  loan.  Thus  Governor  Harding  was  enabled  to 
write  Senator  Smoot  of  Utah  in  the  summer  of  191 1 :  * 

In  view  of  the  fact  that  the  twelve  Federal  Reserve  Banks 
are  independent  bodies  corporate  and  are  controlled  and  directed 
each  by  its  own  board  of  directors,  subject  only  to  the  general 
supervision  of  the  Federal  Reserve  Board,  whose  authority  with 
respect  to  discount  is  confined  principally  to  defining  eligible 
paper  in  accordance  with  the  terms  of  section  13  of  the  Federal 
Reserve  Act,  it  seems  to  me  that  the  statement  which  many, 
both  in  Congress  and  on  the  outside,  urge  be  issued  by  the 
Federal  Reserve  Board,  stating  that  the  Federal  Reserve  Banks 
will  adopt  certain  policies  in  connection  with  the  rediscounting 
of  agricultural  paper,  would  hav^e  to  be  made  by  the  Federal 
Reserve  Banks  themselves.  The  Federal  Reserve  Board  has  no 
power  to  interfere  with  the  discretion  given  or  the  responsibility 
imposed  by  law  upon  the  directors  of  a  Federal  Reserve  Bank 
with  respect  to  passing  upon  the  merits  of  eligible  paper  oflered 
for  discount. 

'This  letter,  written  July  il,  1921,  is  published  in  complete  form,  in  the  Fed- 
eral Reserve  BulUtin,  August,  192 1,  pp.  895-99. 


i8  FEDERAL  RESERVE  POLICY 

Congress  did  not  establish  a  central  bank  in  this  country.  It 
established  twelve  banks  under  the  general  supervision  of  the 
Federal  Reserve  Board,  which  does  not  exercise  banking  functions.^ 
These  functions  are  exercised  exclusively  by  the  Federal  Reserve 
Banks. 

We  are  now  in  a  position  to  derive  a  general  conclusion 
regarding  the  merits  of  the  regional  system.  Politically  it 
appears  to  the  writer  to  have  been  a  clever  device.  It  has 
served  to  some  extent  in  the  past,  and  undoubtedly  should 
serve  to  a  greater  extent  in  the  future,  to  localize  sectional 
complaints,  and  thus  to  ward  off  attacks  which  otherwise 
would  be  launched  upon  the  reserve  system  as  a  whole.  In 
an  administrative  way  it  has  rendered  possible  an  enor- 
mous increase  in  business  with  a  minimum  of  friction. 
Had  the  plan  of  191 3  been  that  of  a  single  central  bank,  it 
is  by  no  means  impossible  that  by  administrative  develop- 
ment it  would  have  been  organized  finally  upon  lines  some- 
what similar  to  those  of  the  reserve  system  of  to-day. 
Many  duties  can  best  be  performed  locally;  district 
branches  must  be  provided  under  any  central  banking 
system  to  assist  in  the  work  of  check  clearances,  examina- 
tions of  condition  of  member  banks,  analysis  of  the  quality 
of  paper  of  local  origin  offered  for  rediscount.  Should  such 
a  system  get  Into  the  market  continuously,  the  w^ork  of 
these  branches  might  not  prove  far  different  from  that  of 
the  regional  banks  of  to-day. 

The  most  vulnerable  point  of  the  regional  system,  in 
the  mind  of  the  writer,  is  the  closeness  of  contact  between 
the  district  directorates  and  the  member  banks.  As  Indi- 
cated previously,  this  feature  was  dependent  upon  the 
desire  to  establish  a  group  of  bankers'  banks  which  should 
exercise  some  measure  of  continuous  control  over  the 
money  market.   The  advantages  of  a  smoothly  working 

'  The  italics  are  the  writer's. 


THE  WORKING  OF  THE  REGIONAL  SYSTEM     19 

system  of  this  sort  are  evident  to  all.  But  unless  there  are 
developed  principles  of  credit  control,  more  sound  econom- 
ically than  those  enunciated  in  the  past,  the  plan  may 
prove  to  have  been  too  ambitious.  It  might  have  been 
better  to  have  proceeded  upon  the  more  modest  lines  of 
devising  merely  an  emergency  machine.  But,  as  it  is,  the 
problem  of  the  future  is  to  develop  sound  rules  for  the 
regulation  of  the  credit  advances  of  a  set  of  banks  per- 
manently in  the  market. 


CHAPTER  II 

CHECK  COLLECTIONS  AND  CLEARANCES  UNDER 
THE  FEDERAL  RESERVE 

The  early  treatment  of  the  subject  of  check  collections 
and  clearances  may  evoke  some  surprise  in  the  mind  of  the 
reader.  In  criticisms  of  the  old  banking  system  following 
the  crisis  of  1907,  principal  attention  was  not  devoted  to 
the  country's  clearance  difficulties,  and  in  most  current 
discussions  major  emphasis  has  been  placed  upon  the  new 
system's  discount  functions.  Nevertheless,  the  writer 
feels  that  the  development  of  the  Federal  Reserve's  par 
clearance  system  should  be  given  a  position  of  prominence. 

Prior  to  1914  clearing  houses  and  clearing  systems 
represented  the  most  important  institutions  of  coopera- 
tion developed  through  the  initiative  of  the  banks  them- 
selves. But  the  work  of  these  institutions  was  not  the 
most  efficiently  coordinated  and  systematized.  In  par- 
ticular, the  various  sections  of  the  country  were  not  served 
by  any  single  set  of  clearing  institutions.  What  has  been 
done  under  the  Federal  Reserve  is  to  establish  common 
centers  for  each  of  the  districts  under  conditions  whereby 
the  work  of  each  will  be  closely  related.  If  we  hold  to  the 
view  that  the  reserve  system  was  established  primarily  to 
secure  more  effective  cooperation  in  banking,  the  impor- 
tance of  the  clearing  functions  of  the  new  banks  is  clear. 

Check  clearances,  moreover,  indicate  more  largely  than 
any  other  single  function  the  need  of  the  continuous  opera- 
tion of  the  reserve  banks.  The  volume  of  rediscounting 
must  alter  greatly  with  changing  business  conditions;  it 


CHECK  COLLECTIONS  AND  CLEARANCES   21 

may  be  that  on  certain  occasions  there  will  be  very  little 
demand  for  the  reserve  system's  funds.  In  the  early  years 
of  operation,  for  instance,  little  success  was  achieved  in 
the  desire  to  get  the  reserve  banks  actively  in  the  money 
market  through  their  discount  functions.  Then,  especially, 
was  it  highly  important  that  a  service  be  developed  for 
which  member  banks  would  find  a  constant  need. 

In  no  matter  of  government  and  administration,  fur- 
thermore, has  more  tact  and  diplomacy  been  required 
than  in  the  efforts  to  extend  the  scope  of  the  reserve  clear- 
ing system.  In  the  early  legislative  history  of  the  statute 
no  provisions  were  more  vehemently  attacked  than  those 
providing  for  country-wide  par  collections.  After  the  date 
of  inauguration  each  step  in  the  development  of  the  clear- 
ing system  has  been  carefully  observed  and  analyzed  by 
the  great  number  of  country  banks.  In  view  of  the  im- 
possibility of  building  an  imposing  reserve  edifice  upon 
the  insufhcient  foundations  of  limited  membership,  this 
attitude  of  the  country  banks  often  compelled  the  modi- 
fications of  plans  which  the  requirements  of  efficiency 
would  otherwise  have  dictated. 

Difficulties  in  check  collections  existing  prior  to  1914 
are  generally  understood.  In  the  first  place,  the  indirect 
routing  of  distantly  drawn  checks  created  much  delay  in 
securing  the  return  of  checks  to  the  drawee  bank.  As  a 
second  aspect  of  this  difficulty  reserves  were  built  up  in  an 
exceedingly  unscientific  manner  and  consisted  frequently 
to  a  large  degree  of  checks  in  the  mails.  In  the  third  place, 
check  collections  were  rendered  more  expensive  because 
the  local  clearing  system  usually  comprised  a  portion  only 
of  the  banks  in  the  locality.  It  is  a  well-known  principle  of 
check  clearances  that  the  possibilities  of  offsetting  clearing 
debits  by  clearing  credits  are  limited  when  the  system  does 
not  embrace  a  large  portion  of  the  banks  which  mutually 


22  FEDERAL  RESERVE  POLICY 

receive  and  collect  each  other's  checks.  One  bank  may 
receive  in  a  day  about  the  same  volume  of  checks  drawn 
against  other  banks  as  the  other  banks  receive  against  it. 
But  there  is  no  guarantee  that  in  a  collection  system  of 
limited  scope  any  one  bank's  credits  may  not  greatly 
exceed  its  debits  and  vice  versa. 

But  to  consider  these  difficulties  more  in  detail,  let  us 
first  turn  our  attention  to  the  matter  of  the  indirect  routing 
of  checks.  The  purpose  of  this  prevailing  custom  was  to 
enable  some  bank  to  avoid  the  deduction  of  exchange 
charges  imposed  by  the  drawee  institution.  Bank  A,  in 
one  district,  receives  checks  drawn  against  Bank  B  in 
another  district.  If  A  sends  these  checks  directly  to  B,  B 
would  customarily  remit  something  less  than  their  full 
face  value.  Justification  for  this  deduction  was  in  part  the 
clerical  labor  and  other  expense  necessitated  in  the  making 
of  remittance.  Bank  B  must  remit  by  dispatching  cur- 
rency by  registered  mail  or  express,  or  by  drawing  against 
a  foreign  balance  previously  established  for  this  particular 
purpose.  The  building-up  of  these  foreign  accounts,  be  it 
by  the  purchase  of  exchange,  the  shipping  of  currency,  or 
the  discounting  of  its  own  note,  was  costly.  Bank  A  in  turn 
might  attempt  to  recoup  itself  for  this  exchange  deduction 
by  imposing  an  exchange  charge  upon  the  individual  who 
deposits  the  check.  In  many  situations,  however,  banking 
customs  were  so  firmly  established  and  banking  competi- 
tion so  keen  as  to  render  impracticable  such  a  practice  in 
the  case  of  regular  clients.  All  the  greater,  consequently, 
was  the  necessity  of  avoiding  if  possible  the  loss  through 
the  deduction  of  exchange  in  Bank  B's  remittance. 

One  of  the  means  of  escaping  such  a  loss  would  be  for 
Bank  A  to  establish  par  relations  with  banks  in  foreign 
territory.  Two  banks  located  in  different  parts  of  the 
country  could  agree  to  collect  for  each  other  checks  drawn 


CHECK  COLLECTIONS  AND  CLEARANCES       23 

against  banks  in  a  certain  prescribed  territory/  Thus 
Bank  A  gives  full  par  credit  to  Bank  C  for  the  deposit  of 
checks  drawn  against  banks  in  the  neighborhood  of  Bank 
A.  Bank  C  does  the  same  for  Bank  A.  If  Bank  B  is  lo- 
cated in  the  district  of  Bank  C,  Bank  A  is  able  to  collect 
through  C  without  loss  checks  drawn  against  B.  But  in 
order  to  induce  some  outside  bank  to  collect  at  par  and 
thereby  absorb  the  exchange  charge,  it  was  often  necessary 
for  one  of  the  banks  to  maintain  a  deposit  balance  in  the 
other.  Thus : 

The  First  and  Old  Detroit  National  Bank  carries  deposits 
accounts  in  banks  scattered  over  the  country  for  the  purpose  of 
getting  checks  collected  at  par.  In  fact  such  checks  are  not 
collected  at  par,  because  the  bank  loses  the  use  of  its  funds  on 
deposit.  The  interest  on  such  funds  is  the  price  paid  for  the 
"par"  collections.' 

But  the  point  most  to  be  emphasized  here  is  that  the 
existence  of  such  par  points  serv^ed  to  impede  the  direct 
return  of  checks.  Instead  of  being  sent  directly  to  the 
drawee  bank  for  remittance,  they  would  be  dispatched  to 
the  par  or  free  city,  where  perhaps  they  would  be  again 
indirectly  routed  to  the  drawee  bank.  Bank  A,  for 
instance,  dispatches  checks  drawn  against  Bank  B  not 
directly  to  B,  but  to  its  collection  correspondent,  Bank  C. 

This  devious  routing  increased  the  number  of  banks 
through  which  the  "homing"  check  passed  and  padded 
the  expenses  of  collection.  But  possibly  more  important 
than  this  increased  expense  was  the  manner  in  which  such 
distantly  drawn  checks  were  customarily  handled  in  the 
creation  of  legal  reserves.   By  the  practice  previously  per- 

'  A  good  account  of  such  arrangements  is  contained  in  an  address  by  William 
J.  Gray,  at  Portland,  Michigan,  August,  1916.  This  address  was  published  in 
the  Michigan  Investor  and  fjuolcd  by  the  Commercial  and  Financial  Chronicle, 
August  19,  1916,  pp.  636-37. 

'Ibid. 


24  FEDERAL  RESERVE  POLICY 

mittcd  by  the  Comptroller  of  the  Currency,  the  country 
bank  remits  a  cash  letter  to  the  bank  which  acts  as  its 
collecting  agent  in  the  reserve  city,  "and  on  that  day 
charges  the  amount  of  that  cash  letter  to  its  reserve  agent 
and  considers  it  a  cash  balance  and  part  of  its  reserve."' 
Needless  to  remark,  the  reserve  agent  may  find  it  impossi- 
ble to  collect  from  the  drawee  bank  for  some  days.  It,  in 
turn,  may  forward  the  check  indirectly  through  one  of  its 
par  correspondents  and  thereby  create  a  reserve  balance 
for  itself.  The  same  check  may  suffice  finally  to  establish 
several  fold  its  face  value  in  reserve  money  before  being 
charged  to  the  account  of  the  drawer.  As  a  final  outcome 
the  check  may  retrace  its  path  marked  "no  funds."  At 
one  time  it  was  estimated  that  the  amount  of  checks  in  the 
mails  —  the  so-called  "float"  —  amounted  to  three  hun- 
dred millions  of  dollars  daily. ^ 

The  desirability  of  correcting  such  evils  as  these  would 
appear  to  have  furnished  sufficient  warrant  for  the  altera- 
tion of  former  collection  methods.  But  certain  special 
circumstances,  possibly  less  fundamental  in  their  impor- 
tance, supplied  in  large  measure  the  raison  d'etre  for  the 
new  machinery.  Among  these  was  the  fact  that  under  the 
reserve  system  it  became  necessary  for  the  reser\^e  banks 
to  assume  many  functions  previously  provided  for  by  the 
city  correspondents  of  the  country  banks.  There  is  no 
doubt  but  that  in  the  discussion  over  banking  reform 
victory  was  won  by  the  "interior"  as  against  the  finan- 
cial interests  in  the  metropolitan  centers.  In  the  panic  of 
1907,  interior  banks  found  themselves  unable  to  secure 
funds  by  drawing  upon  their  New  York  deposits.   This, 

'From  an  address  by  Benjamin  Strong,  Jr.,  delivered  June  24,  1915,  before 
the  New  York  State  Bankers'  Association  at  Saratoga  Springs,  New  York.  A 
portion  of  this  address  is  pubHshed  in  the  Ecoiianiic  World,  July  17,1915,  pp. 
74-76. 

'  Cf.  E.  W.  Kemmerer,  TJie  A  B  C  of  tJte  Federal  Reserve  System,  pp.  20-21. 


CHECK  COLLECTIONS  AND  CLEARANCES       25 

above  all,  explains,  in  the  opinion  of  the  writer,  the  willing- 
ness of  the  country  banker  to  lend  an  ear  to  discussions  of 
banking  reform.  Academic  criticisms  of  the  old  methods 
were  not  nearly  so  determining. 

But  what  was  the  source  of  the  1907  difficulty  in  the 
financial  centers?  Was  it  not  primarily  this  —  bankers' 
balances  were  not  invested  properly,  were  not  kept  in 
sufficiently  liquid  form?  Therefore  must  there  be  set  up 
new  institutions  whose  resources  should  be  available  for 
the  members  in  time  of  need,  institutions  whose  invest- 
ments must  be  kept  liquid.  The  reserve  banks  were  to 
become  the  city  correspondents  of  country  banks.  But  if 
the  reserve  banks  were  to  function  in  this  manner  they 
must  give  credit  for  checks  forwarded  for  collection  by  the 
member  institutions.  Otherwise  the  member  banks  would 
find  the  new  machinery  costly.  To  the  foreign  deposits 
established  for  purposes  of  collection  must  be  added 
deposits  the  Reserve  Act  required  to  be  kept  with  reserve 
banks.  To  avoid  such  duplication  of  deposits  and,  accord- 
ingly, of  expense,  the  reserve  banks,  themselves,  must  act 
as  collection  agents.  But  if  the  credits,  the  reser\'es,  of 
member  banks  were  to  be  real  and  not  hypothetical,  the 
old  method  of  establishing  reserves  must  be  modified. 
The  "float"  feature  must  be  abolished. 

Banking  reform,  moreover,  was  not  solely  the  result  of 
criticism  by  bankers.  It  was  to  a  very  great  degree  the 
result  of  the  demands  of  business  which  had  been  insisting 
for  years  that  exchange  exactions  were  unduly  burdensome. 

It  has  been  stated  previously  that,  in  their  eagerness 
to  secure  deposits  of  country  banks,  city  institutions 
were  often  willing  to  absorb  exchange  charges  by  giving 
immediate  and  full  credit  for  the  deposit  of  country  bank 
checks.  Often  no  attempt  was  made  to  recover  this  loss 
from  the  public.    Nevertheless,  the  amount  of  exchange 


26  FEDERAL  RESERVE  POLICY 

charges  paid  by  the  pubHc  aggregated  an  enormous  sum 
and  there  was  an  insistent  demand  that  by  the  estabUsh- 
ment  of  more  efficient  methods  of  check  collections  the 
burden  borne  by  the  pubHc  should  be  lightened. 

These  exchange  exactions,  moreover,  were  not  always 
imposed  equitably,  a  feature  which  served  to  increase  the 
public  discontent.  In  Baltimore,'  for  instance,  there  was 
an  old  rule  of  the  Clearing  House  that  out-of-town  items 
would  be  taken  at  par  only  from  depositors  who  had  been 
regular  customers  of  their  banks  at  the  time,  years  ago, 
when  a  new  rule  was  adopted  requiring  such  charges  of 
new  depositors.  But  if  an  old  customer  should  change  his 
account  to  another  bank,  he  was  considered  as  a  "new 
account"  and  lost  his  privilege  of  depositing  at  par. 
Change  from  one  bank  to  another  was  not  free.  New  cor- 
porations and  new  enterprises  explained  their  hesitancy 
to  establish  themselves  in  this  city  on  the  ground  that  they 
would  be  handicapped  in  their  competition  with  the  older 
firms.  In  one  case  the  par-deposit  privilege  was  lost  merely 
by  a  change  in  the  firm  name.  The  new  name  compelled 
the  application  of  the  rule  applying  to  new  businesses. 
Amid  such  conditions  as  these  there  was  a  widespread 
demand  that  the  reserve  system  provide  for  the  limitation 
of  such  exchange  exactions. 

In  the  earlier  legislative  stages  of  the  Federal  Reserve 
Act  provisions  were  inserted  the  intent  of  which  was  to 
eliminate  these  charges  entirely.  But  the  bill  thus  framed 
met  speedy  and  vigorous  objection  on  the  part  of  a  great 
majority  of  the  exchange-charging  banks.  Many  country 
banks  asserted  that  the  elimination  of  such  charges  would 
impair  very  seriously  their  profits.  Nor  would  they  accept 
the  argument  that  in  the  course  of  time  their  interest 

'Cf.  weekly  circular  of  Nelson,  Cook  &  Co.,  of  Baltimore,  issued  August  5, 
1916.  References  to  this  circular  are  to  be  found  in  the  Commercial  and  Finan- 
cial Chronicle,  August  12,  1916,  p.  534. 


CHECK  COLLECTIONS  AND  CLEARANCES       27 

charges  automatically  would  be  increased  to  compensate 
for  such  loss;  that  since  the  competition  between  banks 
must  determine  the  rates  on  bank  loans,  equal  treatment 
to  all  could  mean  no  discrimination  against  any  one  in  par- 
ticular. Country  banks  maintained  that  in  many  situa- 
tions local  competition  was  not  operative  in  large  degree; 
that  custom  and  law  were  frequently  so  determinative  as 
to  prevent  the  shifting  of  such  loss  to  the  borrowing  pub- 
lic. All  banking  communities,  furthermore,  display  some 
rivalry  one  with  another.  The  time  has  passed  when 
banking  custom  can  decree  uniformly  that  a  local  indus- 
try shall  depend  exclusively  upon  the  local  bank.  Elimina- 
tion of  such  charges  would  handicap  most  those  institu- 
tions which  in  the  past  had  depended  upon  exchange  for  a 
considerable  portion  of  their  profits.  By  the  proposed  new 
law  the  city  institutions  would  often  gain  more  than  they 
would  lose.  In  the  past  many  of  them  had  been  willing  to 
absorb  such  charges  for  the  privileges  of  receiving  the 
accounts  of  the  country  banks.  It  was  often  forgotten  that 
under  the  Reserve  Act  these  city  institutions  stood  to  lose 
a  large  portion  of  bankers'  deposits  through  the  transfer  of 
reserves  to  the  reserve  banks.  It  was  accordingly  asserted 
that  the  elimination  of  exchange  charges  must  affect  most 
injuriously  those  banking  institutions  which  previously 
had  experienced  the  greatest  difficulties  in  realizing  reason- 
able profits. 

The  collective  legislative  influence  of  the  country 
bankers  was  enormous.  Not  merely  did  their  number 
enable  them  to  bring  pressure  to  bear  upon  ver>'  many 
legislators,  but  it  was  peculiarly  essential  that  the  provi- 
sions of  the  act  be  not  such  as  to  cause  the  refusal  of  any 
large  number  of  eligible  banking  institutions  to  join  the 
system.  It  is  not  difficult,  then,  to  account  for  the  altera- 
tion in  the  terms  of  the  bill  according  to  which  it  was 


28  FEDERAL  RESERVE  POLICY 

expressly  stipulated  that  nothing  in  the  act  should  be  so 
construed  as  to  prohibit  a  member  bank  from  charging  its 
actual  expenses  incurred  in  collecting  and  remitting  funds, 
or  for  exchange  sold  its  patrons. 

We  may  now  summarize  the  various  provisions  of  the 
act  as  finally  enacted  dealing  with  check  collections  and 
clearances.  First,  there  was  the  provision  of  section  i6 
that 

Every  Federal  reserve  bank  shall  receive  on  deposit  at  par 
from  member  banks  or  from  Federal  reserve  banks  checks  and 
drafts  drawn  upon  any  of  its  depositors,  and  when  remitted  by 
a  Federal  reserve  bank,  checks  and  drafts  drawn  by  any  depos- 
itor in  any  other  Federal  reserve  bank  or  member  bank  upon 
funds  to  the  credit  of  said  depositor  in  said  reserve  bank  or 
member  bank.' 

This  provision  is  made  subject  to  the  exception  noted 
above.  Since  a  Federal  Reserve  Bank  is  thus  required  to 
give  credit  to  other  banks,  economy  and  efficiency  would 
demand  that  it  clear  the  checks  thus  received,  in  order  to 
employ  the  most  economical  method  of  determining  the 
net  credit  or  debit  balance  due  from  or  to  any  bank. 
Accordingly  there  was  enacted  the  further  provision  in  the 
same  section  that  the  Federal  Reserve  Board 

may  also  require  each  such  [reserve]  bank  to  exercise  the  func- 
tions of  a  clearing  house  for  its  member  banks. 

This  last-quoted  provision  would  concern  intra-district 
clearings.  But  the  receipt  by  one  reserve  bank  of  checks 
drawn  against  member  banks  in  other  districts  would 
create  debits  and  credits  among  the  various  reser\'e  banks. 
Bank  A  of  district  one  receives  credit  for  a  check  drawn 
against  Bank  B  of  district  two.  The  reserve  bank  of  dis- 
trict one  recoups  itself  by  charging  to  the  reser\^e  bank  of 
district  two.   In  similar  fashion  the  reserve  bank  of  district 

'A  similar  provision  was  contained  in  the  first  paragraph  of  section  13. 


CHECK  COLLECTIONS  AND  CLEARANCES       29 

three  receives  items  collectible  in  district  two  and  vice 
versa.  Accordingly  another  sentence  of  section  16  gives 
the  Federal  Reserve  Board  discretionary  power  to 

exercise  the  functions  of  a  clearing  house  for  such  Federal  re- 
serve banks. 

This,  as  noted  in  Chapter  I,  made  necessary  the  later 
establishment  of  the  Gold  Settlement  Fund  at  Washington. 

From  the  wording  of  the  act,  it  would  appear  as  if  the 
exchange-charging  banks  had  won  a  complete  victor}\ 
The  law  provided  that  the  reserve  banks  "shall"  receive 
at  par  checks  drawn  on  member  banks.  It  furthermore 
reserved  expressly  the  right  to  the  drawee  bank  to  deduct 
reasonable  exchange  for  expenses  incurred  in  collecting 
and  remitting  funds.  Must  not  the  reserve  banks  be 
obliged,  therefore,  to  absorb  the  costs  of  collecting  checks? 

Means  of  escaping  the  absorption  of  such  charges  would 
seem  to  lie,  therefore,  in  the  following  lines  of  action: 
First,  the  "  shall "  in  the  clause  of  section  16  above  referred 
to  might  be  construed  as  permissive  and  not  mandatory\^ 
Such  a  construction,  however,  was  unlikely,  as  it  would 
involve  a  perversion  of  the  meaning  usually  understood  to 
pertain  to  the  word  "shall."  Second,  the  reserve  bank 
might  agree  to  bear  the  expense  of  remittance  of  funds 
from  member  to  reserve  banks, .  and  thus,  by  eliminating 
this  item  of  expense,  destroy,  partially  at  least,  the  right 
of  the  drawee  bank  to  charge  exchange.  If  necessary 
checks  could  be  presented  at  the  counter  and  their  full 
face  value  demanded.  In  the  third  place,  the  permissive 
"may"  of  the  last  paragraph  of  section  16,  relating  to  the 
clearing  functions  of  reserve  banks,  might  be  so  construed 
as  to  deny  membership  in  the  clearing  system  to  those 
member  banks  which  insisted  on  deducting  exchange.    In 

'  Some  slight  confirmation  of  this  view  is  afTorded  by  the  fact  that  the  similar 
provision  of  section  13  contained  the  permissive  "may." 


30  FEDERAL  RESERVE  POLICY 

other  words,  the  permissive  "may"  might  enable  reserve 
banks  to  refuse  to  clear  for  banks  which  would  not  agree 
to  whatever  conditions  should  be  imposed  upon  clearing 
members.  One  of  these  conditions  might  be  the  agreement 
of  a  member  bank  to  remit  at  par.  The  final  outcome  of 
the  clearance  problem  must  depend  much  upon  future 
statutory  interpretation  and  administrative  procedure. 

Because  the  work  of  the  reserve  banks  must  be  built  up 
anew  on  bed-rock  foundations,  it  was  not  to  be  expected 
that  the  reserve  banks,  immediately  in  1914,  should  begin 
the  exercise  of  all  the  functions  contemplated  for  ultimate 
development.  Neither  was  it  expected  that  the  various 
reserve  banks  should  all  operate  at  the  outset  in  precisely 
the  same  manner.  Beginnings  were  slow  and  varied  much 
between  the  various  district  banks.  In  the  early  days  the 
New  York  Reserve  Bank,  for  instance,  would  receive 
checks  drawn  only  on  reserve  banks  and  those  drawn  by 
a  member  bank  on  another  member  institution  in  the 
cities  of  New  York,  Albany,  and  Brooklyn.'  On  December 
I,  1914,  the  Federal  Reserv^e  Board  granted  the  reserve 
bank  of  Kansas  City  power  to  clear  checks  presented  by 
member  banks  drawn  on  member  banks.^  St.  Louis  was 
also  among  the  first  to  provide  such  service  and  on  the  4th 
of  March,  1915,  it  was  announced  by  the  Board  that  the 
Chicago  Federal  Reserve  Bank  had  been  clearing  checks 
between  the  member  banks  of  the  seven  Reserve  and  Cen- 
tral Reserve  cities  of  the  district.^  But  on  the  same  date  it 
was  announced  that  only  three  reserve  banks,  those  of 
Kansas  City,  St.  Louis,  and  Chicago,  had  taken  advan- 
tage of  the  clearance  privileges  conferred  by  the  act. 

'  Cf .  letter  by  Governor  Strong,  of  the  New  York  Reserve  Bank,  in  the  Com- 
mercialand  Financial  Chronicle,  December  5,  1914,  p.  1636. 

'Cf.  Commercial  and  Fi7iancial  Chronicle,  December  5,  1914,  p.  1635. 
sCf.  ibid.,  March  13,  1915,  p.  867. 


CHECK  COLLECTIONS  AND  CLEAR.\NCES       31 

Aside  from  the  initial  pressure  of  new  work  and  duties 
there  were  additional  reasons  for  delay.  Inter-district 
clearings  awaited  the  development  of  the  Gold  Settlement 
Fund,  an  undertaking  not  successfully  completed  until 
June,  1915.^  Intra-district  clearings  uncovered  some  legal 
objections, 

it  being  argued  that  there  is  no  power  to  compel  a  member  bank 
not  located  in  a  Federal  Reserve  city  to  pay  or  have  charged  to 
its  account  at  the  Federal  Reserve  Bank  of  its  district  a  check 
which  it  had  not  seen  and  approved  prior  to  the  times  of  presen- 
tation at  its  own  counter.* 

There  was  also  a  natural  hesitancy  to  establish  a  clearing 
system,  which,  on  the  one  hand,  might  admit  the  right 
of  the  drawee  bank  to  charge  exchange,  or,  on  the  other 
hand,  to  create  early  opposition  to  the  system  by  definitely 
eliminating  such  charges.  Furthermore,  because  final 
transfer  of  reserves  to  reserve  banks  was  not  to  be  com- 
pleted for  three  years,  financial  considerations  created 
some  solid  basis  for  opposition  to  the  immediate  introduc- 
tion of  a  complete  clearance  system  which  might  neces- 
sitate the  maintenance  of  balances  with  reserve  banks. 
During  the  period  in  which  reser\^es  could  be  kept  par- 
tially with  city  institutions,  it  might  be  a  hardship  to  com- 
pel city  banks  to  give  up  this  clearance  work  to  the  reserve 
or  to  compel  country  banks  to  transfer  balances  to  the 
reserve  institutions  for  clearing  work.  Balances  with  the 
reserve  banks  would  draw  no  interest.  For  these  various 
reasons  the  Reserve  Board  began  to  work  first  on  the 
establishment  of  a  voluntary-reciprocal  plan  of  clearances. 
It  was  believed  that  sufiiclcnt  success  might  be  achieved 
with  such  a  system  to  render  unnecessary  measures  ultra- 
compulsory  in  nature. 

'  Cf.  Report  of  the  Federal  Reserve  Board  for  the  year  1915,  p.  14. 
*Ibid.,  p.  15. 


32  FEDERAL  RESERVE  POLICY 

In  the  spring  of  19 15  the  Federal  Reserve  Board  began 
to  send  to  the  various  reserve  banks  descriptive  circulars 
of  the  new  voluntary-reciprocal  plan.'  According  to  this 
plan  membership  was  to  be  purely  voluntary.  Checks 
would  not  be  cleared  drawn  upon  banks  which  would  not 
agree  to  remit  at  par.  But,  on  the  other  hand,  banks  not 
agreeing  to  remit  the  full  face  value  of  checks  drawn 
against  them  could  not  avail  themselves  of  the  facilities 
of  the  reserve  system  in  collecting  checks  drawn  upon 
other  banks.  Details  of  operation  would  differ  in  the  vari- 
ous districts.  In  the  Chicago  district,^  the  costs  of  operat- 
ing the  system  were  to  be  borne  by  the  reserve  bank  and 
each  bank  must  maintain  sufficient  funds  on  deposit  with 
the  reserve  bank  to  permit  the  immediate  charge  of  debit 
balances.  The  amount  of  such  balances  would  be  deter- 
mined by  experience  gained  as  the  system  continued  its 
operation.  But  regardless  of  the  details,  the  clearing  sys- 
tem in  each  district  was  to  be  open  to  every  bank  which 
would  agree  to  permit  the  deduction  at  par  of  its  own  debit 
items.  The  motives  for  joining  the  system  would  be:  first, 
the  economies  realizable  in  the  collection  of  checks  drawn 
against  other  banks;  second,  increased  acceptability  of 
the  member's  own  checks. 

In  the  opinion  of  the  great  majority  of  the  banks,  how- 
ever, either  the  time  for  entrance  was  inopportune,  or  the 
obligations  greatly  outweighed  the  privileges.  By  Janu- 
ary, 1916,  it  was  stated  Hhat  only  about  twenty-six  hun- 
dred out  of  a  total  number  of  eight  thousand  member 
institutions  had  subscribed  to  the  provisions  necessary 
for  admittance.  Accordingly,  the  Board  felt  that  more 
compulsory  measures  were  necessary.  As  a  consequence 
of  this  belief  there  was  devised  a  new  system  which  began 

'  Cf.  Bulletin,  May  I,  19 15,  pp.  6-7.  '  Cf.  ibid.,  pp.  7-9. 

3  Cf.  Commercial  and  Financial  Chronicle,  January  i,  1916,  p.  15. 


CHECK  COLLECTIONS  AND  CLEARANCES      33 

operation  on  July  15,  1916.  This  plan  provided  the  nucleus 
for  the  development  of  the  present  clearance  system. 

By  the  terms  of  this  new  plan,  member  banks,  regard- 
less of  their  own  volition,  were  to  be  required  to  pay  with- 
out deduction  checks  drawn  upon  themselves  and  pre- 
sented at  their  own  counters.  Remittance  by  the  reserve 
banks  through  the  mail  was  to  be  construed  as  presenta- 
tion at  their  own  counters.  Settlement  could  be  made  by 
acceptable  checks  on  other  banks  or  by  the  shipment  of 
lawful  money  or  Federal  Reserve  notes '  at  the  expense  of 
the  reserve  bank.  It  would  not  be  necessary,  therefore,  for 
banks  to  maintain  balances  at  reserve  banks  for  clearing 
purposes.  For  its  services  as  a  collection  agent  the  reserve 
bank  could  collect  a  small  service  charge  of,  say,  one  and  a 
half  to  two  cents  an  item  from  the  bank  for  whom  collec- 
tions were  made.  In  the  course  of  time,  however,  such 
charges  were  eliminated. 

The  only  compulsory  feature  of  the  new  plan  was  that 
requiring  payment  at  par  from  drawee  member  banks. 
Member  banks  were  free  to  keep  clearing  balances  else- 
where and  to  clear  through  private  agencies  if  they  so 
desired.  But  it  was  not  believed  that  many  member  banks 
would  find  it  to  their  advantage  to  clear  elsewhere  than 
through  the  reserve.  If  they  must  remit  at  par  to  the 
reserve  banks,  why  not  gain  the  advantages  of  collection 
of  credit  items  at  par?  By  construing  the  sending  of  checks 
through  the  mails  as  presentment  at  the  counter,  it  was 
believed  that  legal  objection  could  not  be  made  to  the 
denial  of  the  right  of  a  bank  to  deduct  exchange. 

Under  the  new  system  checks  would  also  be  received 
drawn  upon  such  non-member  institutions  as  could  be 
collected  at  par.  Desire  to  avail  of  the  economics  in  the 
collection  of  credit  items  and  to  increase  the  circulatory 

'  See  Bulletin,  June  i,  1916,  pp.  262-64. 


34  FEDERAL  RESERVE  POLICY 

power  of  their  own  checks  might  be  appealing  motives 
influencing  non-member  institutions  to  remit  at  par.  To 
make  the  law  more  clear  regarding  the  status  of  non- 
member  banks,  an  amendment  was  secured  to  the  Federal 
Reserve  Act  on  September  7,  19 16,  expressly  permitting 
reserve  banks  to  receive  deposits  of  all  checks  and  drafts 
payable  upon  presentation. 

This  amendment,  however,  contained  no  mandatory 
provision  regarding  the  remittances  of  State  banks.  Re- 
fusal of  any  large  number  of  such  banks  to  become  clearing 
members  must  weaken  the  system  seriously.  The  services 
rendered  by  the  reserve  banks  must  depend  upon  the 
volume  of  checks  collectible  for  each  clearing  member. 
Consequently,  some  of  the  reserve  banks  began  to  search 
for  various  means  of  compelling  membership.  The  meas- 
ures adopted  were  often  expensive,  but  were  undertaken, 
nevertheless,  on  the  theory  that  if,  by  presentation  at  the 
counter,  the  State  banks  could  be  forced  to  make  par 
remittance,  they  would  perceive  the  desirability  of  joining 
the  reserve  clearance  system  and  thereby  gain  whatever 
advantages  this  system  offered  as  an  agency  for  the  col- 
lection of  their  own  credit  items. 

Collection  at  the  counter  necessitated  local  agencies  to 
protest  items  not  promptly  paid.  In  case  a  member  bank 
was  located  in  the  town,  there  would  be  no  great  difficulty 
in  establishing  such  an.  agency.  Otherwise  arrangements 
must  be  made  to  secure  the  services  of  some  other  institu- 
tion. At  one  time  a  project  was  developed  whereby  post- 
masters might  act  as  agents  of  the  reserve  banks  in  towns 
where  no  member  bank  was  situated.^  But  undoubtedly 
because  of  its  doubtful  political  expediency  this  project 
was  abandoned.  Often  notaries  and  express  agents  would 
be  employed.   In  some  cases  it  is  asserted  that  the  reserve 

'  Cf.  Commercial  and  Financial  Chronicle,  July  22,  1916,  p.  284. 


CHECK  COLLECTIONS  AND  CLEARANCES      35 

bank  or  Its  agent  would  save  up  the  checks  of  the  State 
bank  until  they  amounted  to  a  considerable  volume.  Then 
they  would  be  dispatched  to  the  drawee  bank  by  automo- 
bile or  otherwise  and  presented  in  bulk. 

Such  arrangements  were  pushed  zealously  and  possibly 
in  some  cases  with  excessive  vigor.  In  an  address  delivered 
in  the  House,  Representative  Reavis  complained  on  one 
occasion  that  in  the  town  of  Pierce,  Nebraska,  representa- 
tives of  the  reserve  bank  saved  up  checks  until  they 
amounted  to  ^41,000.'  Then  they  went  in  an  automobile 
to  this  town  and  demanded  payment  in  cash.  Inasmuch 
as  every  bank  bases  its  operations  on  an  approximate 
daily  correspondence  of  daily  income  and  daily  outgo,  such 
measures  must  prove  exceedingly  embarrassing.  Repre- 
sentative Reavis  also  charged  that  in  its  endeavor  to  force 
this  bank  to  terms  the  reserve  bank  had  a  man  on  the 
ground  endeavoring  to  organize  a  competing  national  bank. 

These  attempts  at  coercion  inevitably  occasioned  the 
utmost  of  protest  by  the  non-member  State  banks.  Their 
protests  were  expressed  in  various  ways.  Bankers'  asso- 
ciations were  exhorted  to  exert  pressure  in  their  behalf, 
and  efforts  were  made  to  secure  the  enactment  of  legisla- 
tion prohibiting  the  coercive  measures.  In  suits  at  law, 
moreover,  the  reserve  banks  were  accused  of  exceeding 
their  lawful  powers. 

As  an  outcome  of  such  protests  laws  were  enacted  in 
several  States  unfriendly  to  the  Board's  plans.  Among 
these  States  were  North  Carolina,  Tennessee,  and  Missis- 
sippi. As  a  type  of  such  legislation  the  Mississippi  law  is 
well  worth  summarizing.^  First,  it  definitely  legalized  what 
it  called  "the  established  custom"  of  banks  of  that  State 

'  Extracts  from  this  address  arc  piililishcd  in  the  Commercial  and  Financial 
Chronicle,  February  7,  1920,  pp.  515-16. 
*  The  complete  text  of  this  law  may  be  found  in  the  Bulletin,  April,  1920,  p.  387. 


36  FEDERAL  RESERVE  POLICY 

to  charge  a  service  fee  commonly  called  exchange  for  col- 
lection and  remittance.  Second,  banks  were  given  discre- 
tionary power  to  deduct  exchange  on  items  presented  by 
any  bank,  "post-office,  express  company,  or  any  collection 
agency,  or  by  any  other  agency  whatsoever."  In  the  third 
place.  State  officers  were  deprived  of  power  to  "protest 
for  nonpayment  any  such  'cash  item*  when  such  non- 
payment is  solely  on  account  of  the  failure  of  any  of  such 
agencies  to  pay  such  exchange."  Furthermore,  there 
should  be  "no  right  of  action,  either  at  law  or  in  equity, 
against  any  bank  in  this  State  for  refusal  to  pay  such  cash 
item,  when  such  refusal  is  based  alone  on  the  ground  of  the 
nonpayment  of  such  exchange." 

Various  suits  at  law  were  begun  also  to  test  the  validity 
of  the  coercive  measures.  The  most  important  of  these  was 
the  American  Bank  and  Trust  Company  et  al.  v.  Federal 
Reserve  Bank  of  Atlanta.  On  appeal  this  suit  was  brought 
to  the  Supreme  Court  of  the  United  States.^  In  this  case 
it  was  alleged  that  the  practice  of  the  Atlanta  Reserve 
Bank  had  been  to  accumulate  a  large  number  of  checks 
upon  the  exchange-charging  banks,  then  present  them  at 
the  counter,  and  demand  cash  in  payment.  It  was  com- 
plained that  such  methods  were  employed  with  malicious 
intent,  for  the  purpose  of  injuring  the  business  of  the  non- 
member  drawee  banks.  In  the  decision  of  the  district 
court  it  was  held  that  the  defendant's  right  to  cash  checks 
in  this  way  was  absolute,  and  that  the  matter  of  malicious 
intent  was  irrelevant.  This  ruling,  however,  was  reversed 
in  the  decision  of  the  higher  court.  Consequently  the  case 
w^as  remanded  to  the  original  court  for  decision  upon  its 
merits. 

Because   of   its   probable   future   Importance,    certain 

'  The  opinion  delivered  by  Mr.  Justice  Holmes  is  printed  in  the  Bulletin, 
June,  192 1,  pp.  700-01. 


CHECK  COLLECTIONS  AND  CLEARANCES       37 

remarks  of  Mr.  Justice  Holmes,  who  delivered  the  opinion 
for  the  Supreme  Court,  are  well  worth  quoting.  Thus: 

The  defendants  say  that  the  holder  of  a  check  has  a  right  to 
present  it  to  the  bank  upon  which  it  was  drawn  for  payment 
over  the  counter,  and  that  however  many  checks  he  may  hold 
he  has  the  same  right  as  to  all  of  them  and  may  present  them  all 
at  once,  whatever  his  motive  or  intent.  .  .  .  But  the  word 
"right"  is  one  of  the  most  deceptive  of  pitfalls;  it  is  so  easy  to 
slip  from  a  qualified  meaning  in  the  premise  to  an  unqualified 
one  in  the  conclusion.  Most  rights  are  qualified. 

And  then,  after  a  few  illustrations  of  the  necessity  of 
guarding  carefully  our  concept  of  "rights": 

Banks,  as  we  know  them,  could  not  exist  if  they  could  not 
rely  upon  averages  and  lend  a  large  part  of  the  money  that  they 
receive  from  their  depositors  on  the  assumption  that  not  more 
than  a  certain  fraction  of  it  will  be  demanded  on  any  one  day. 
If  without  a  word  of  falsehood,  but  acting  from  what  we  have 
called  disinterested  malevolence,  a  man  by  persuasion  should 
organize  and  carry  into  effect  a  run  upon  a  bank  and  ruin  it,  we 
can  not  doubt  that  an  action  would  lie. 

To  determine  the  lawful  procedure  for  the  defendants  (the 
reserve  bank) 

it  is  not  enough  to  refer  to  the  general  right  of  a  holder  of  checks 
to  present  them,  but  it  is  necessary  to  consider  whether  the 
collection  of  checks  and  presenting  them  in  a  body  for  the  pur- 
pose of  breaking  down  the  petitioner's  business  as  now  con- 
ducted is  justified  by  the  ulterior  purpose  in  view. 

The  probable  results  of  this  decision  were  variously 

interpreted.    Many  exchange-charging  banks  hailed  it  as 

the  legal  solution  of  their  difficulties,  and  predicted  as  the 

final  outcome  the  withdrawal  of  many  non-member  banks 

from  the  par  list  and  the  final  acknowledgment  by  the 

reserve  institutions  of  the  drawee  bank's  right  to  deduct 

exchange.    In  this  vein  writes  Mr.  L.  R.  Adams,*  in  the 

Journal  of  the  American  Bankers'  Association:^ 

'  Mr.  Adams  was  secretary-treasurer  of  the  Country  Bankers'  Association 
of  Georgia.  »  Issue  of  June,  192 1,  pp.  776-7<>. 


38  FEDERAL  RESERVE  POLICY 

We  anticipate  that  the  final  effect  of  the  Supreme  Court's 
decision  will  be  that  both  member  and  non-member  banks  will 
be  given  the  right  to  charge  reasonable  exchange  on  checks 
cleared  through  the  Federal  reserve  system  or  otherwise.  How- 
ever that  may  be,  it  appears  that  the  country  banks  of  Georgia 
.  .  .  have  laid  out  a  road  which  the  Supreme  Court  has  paved 
with  concrete  principles  of  justice,  over  which  the  non-member 
banks  may  safely  and  smoothly  travel,  using  as  a  vehicle  the 
equity  processes  of  the  Federal  courts,  to  a  safe  haven  in  which 
they  may  exercise  their  lawful  functions  without  fear  of  "embar- 
rassing, annoying  and  expensive"  methods  of  forcing  their  com- 
pliance with  unauthorized  demands. 

When  the  case  was  remanded  to  the  lower  court,  how- 
ever, for  a  decision  on  its  merits,  the  opinion  of  the  court 
was  hostile  to  the  plaintiffs.  United  States  District  Judge 
Beverly  D.  Evans  held^  that  the  reserve  banks  properly 
could  collect  all  checks  payable  upon  presentation,  includ- 
ing checks  drawn  on  non-member  banks,  and  that  they 
could  not  pay  any  exchange  charges.  As  regards  the 
method  of  collection  the  court  stated : 

(3)  In  the  discharge  of  its  duties  with  respect  to  the  collection 
of  checks  deposited  with  them,  and  with  respect  to  performing 
the  functions  of  a  clearing  house,  the  several  Federal  reserve 
banks  are  empowered  to  adopt  any  reasonable  measure  designed 
to  accomplish  these  purposes.  To  that  end  a  Federal  reserve 
bank  may  send  checks  to  the  drawee  bank  directly,  for  remit- 
tance through  the  mails,  of  collections  without  cost  of  exchange. 
If  the  drawee  bank  refuses  to  remit  without  deduction  of  the 
cost  of  exchange,  it  is  in  the  power  of  the  several  Federal  reserve 
banks  to  employ  any  proper  instrumentality  or  agency  to  col- 
lect the  checks  from  the  drawee  bank,  and  it  may  legitimately 
pay  the  necessary  cost  of  this  service. 

(4)  The  process  of  the  daily  collection  of  checks,  in  the  exer- 
cise of  the  clearing-house  functions,  is  not  rendered  unlawful 

'  This  opinion  is  printed  in  the  April,  1922,  Bulletin,  p.  436. 


CHECK  COLLECTIONS  AND  CLEARANCES      39 

because  of  the  fact  that  of  the  checks  handled  two  or  more  of 
them  may  be  drawn  on  the  same  bank. 

Only  in  one  respect  did  this  opinion  grant  comfort  to 
the  complaining  banks.  It  was  held  that  there  should  not 
be  publication  on  the  par  list  of  the  name  of  a  non-member 
bank  without  its  consent.  While  it  might  be  true  that  the 
checks  of  a  certain  non-member  bank  could  be  collected 
at  par,  it  might  also  be  that  this  bank  had  not  consented  to 
the  par  clearance  plan.  But  this  is  a  matter  of  minor 
importance. 

But  before  the  opinion  of  Judge  Evans  was  announced 
it  did  not  appear  to  the  writer  that  the  enthusiastic  predic- 
tions of  Mr.  Adams  could  be  fulfilled.  It  would  seem  as  if 
always  the  burden  of  proof  regarding  the  matter  of  mali- 
cious intent  would  rest  on  the  complainants.  Furthermore, 
courts,  very  likely,  will  be  inclined  to  be  liberal  in  inter- 
preting the  collection  difficulties  of  the  reserve  banks.  It 
cannot  be  expected  that  the  reserve  bank  shall  submit  to 
unnecessary  expense  in  the  collection  of  a  single  check. 
Economy  will  justify  their  collection  in  batches.  To 
determine  when  malicious  motives  are  present  will  require 
special  evidence  in  every  case.  The  expense  of  such  litiga- 
tion may  operate  to  deter  many  of  the  small  country 
banks  from  bringing  suit.'  Finally,  not  everything  in  the 
opinion  of  Justice  Holmes  was  favorable  to  the  contention 
of  the  plaintiffs.  For  one  matter,  it  was  held  that  in  a 
case  of  this  sort  the  Federal  and  not  the  State  courts 
possessed  jurisdiction.  If  it  be  true  that  the  general  body 
of  business  opinion  is  hostile  to  the  exchange  charges,  re- 
serve banks  may  prefer  to  have  such  cases  decided  in  the 
United  States  courts,  which  are  more  likely  to  be  in- 
fluenced by  the  general  attitude  of  the  country  as  a  whole 
and  not  that  of  a  single  community. 

'  Of  course  attempts  may  be  made  to  distribute  this  expense  through  the  for- 
mation of  associations  of  bankers. 


40  FEDERAL  RESERVE  POLICY 

If  this  conclusion  be  correct,  relief  for  the  exchange- 
charging  banks  can  be  had  only  by  securing  changes  in  the 
Federal  statute.  As  a  matter  of  previous  development 
such  statutory  alterations  already  had  been  vigorously 
attempted.  At  first  only  success  was  achieved.  In  the 
spring  of  19 17  the  so-called  Hard  wick  amendment  to  the 
Federal  Reserve  Act  was  passed  in  the  Senate  expressly 
legalizing  the  deduction  by  the  drawee  bank  of  a  reason- 
able charge  for  the  collection  and  remittance  expenses,  and 
in  the  House,  on  May  10,  191 7,  by  a  vote  of  more  than  two 
to  one,  conferees  were  directed  to  accept  the  substance  of 
this  amendment.  Before  the  conferees  came  to  an  agree- 
ment, however,  it  was  charged  that  intensive  lobbying  was 
employed  in  order  to  defeat  the  amendment.  Regarding 
this  Mr.  Thralls  states: ' 

A  nation-wide  campaign  had  been  conducted  by  the  Credit 
Men's  Association,  the  mail-order  houses,  manufacturers, 
jobbers,  wholesalers,  and  merchants  in  the  large  centers  for  the 
defeat  of  the  Hardwick  amendment.  These  interests  were  ably 
assisted  by  the  Federal  Reserve  Banks. 

Material  changes,  which  if  literally  interpreted  will  defeat  the 
purpose  of  the  amendment,  were  made  in  conference.  When 
the  bill  was  reported  for  consideration  in  the  House,  the  point  of 
order  that  the  managers  of  the  House  had  not  obeyed  instruc- 
tions was  overruled.  This  ruling,  in  the  minds  of  many,  is  con- 
trary to  parliamentary  precedents.  The  Administration  pres- 
sure was  turned  on,  and  the  report  was  accepted.  It  contained 
two  modifications: 

1.  Providing  that  the  charges  are  to  be  determined  and  regu- 
lated by  the  Federal  Reserve  Board, 

2.  Providing  that  no  such  charges  shall  be  made  against  the 
Federal  Reserve  banks. 

This  last  modification,  when  it  became  law,  took  the 

'  Cf.  Mr.  Jerome  Thralls,  secretary  of  the  National  Bank  and  Clearing  House 
Sections  of  the  American  Bankers'  Association,  in  the  Jmirnal  of  the  American 
Bankers'  Association  for  July,  1917.  The  substance  of  this  address  is  printed  in 
the  Commercial  and  Financial  Chronicle,  July  21,  1917,  pp.  235-36. 


CHECK  COLLECTIONS  AND  CLEARANCES     41 

teeth  out  of  the  amendment.  It  completely  turned  the 
tables  on  the  exchange-charging  banks.  So  far  as  the  law 
was  altered  at  all,  it  af^rmed  more  definitely  than  ever  the 
right  of  the  reserve  banks  to  refuse  exchange  deductions 
by  drawee  banks. 

Mr.  Thralls's  charge  that  the  Hardwick  amendment  was 
unfairly  defeated  may  be  true.  But  aside  from  the  means 
employed,  the  Federal  Reserve  Board  had  an  exceedingly 
strong  case.  In  the  first  place,  expense  of  remittance  to  the 
collection  agent  was  reduced  by  the  agreement  of  the 
reserve  bank  to  absorb  such  costs  on  checks  cleared 
through  it.  A  part  of  the  justification  for  the  earlier  prac- 
tice was  thus  eliminated.  In  the  second  place,  the  pro- 
hibited charges  related  only  to  those  sought  against  the 
reserve  banks  and  did  not  apply  to  those  levied  upon  the 
public.  In  view  of  the  economies  of  collecting  through 
an  efficient  clearing  system,  such  levies,  however,  should 
be  much  more  reasonable  than  those  exacted  under  the 
old  banking  system.  Banks  would  no  longer  be  obliged 
to  maintain  deposits  in  outside  private  banks  in  order  to 
facilitate  the  collection  of  their  own  checks.  If  the  reserve 
banks  give  credit  at  par,  should  they  not  be  permitted  to 
collect  at  par?  If  the  reserve  banks  are  considered  as  act- 
ing merely  as  an  agent  for  the  member  banks,  elimination 
of  exchange  charges  could  not  affect  them  at  all  in  the 
aggregate.  To  the  extent  that  one  bank  is  denied  an  item 
of  income,  another  is  saved  an  item  of  expense. 

It  will  always  be  extremely  difficult  to  ascertain  the  real 
attitude  of  the  banks  toward  the  Board's  clearance  plan. 
Many  bankers  who  disliked  this  feature  of  reserve  opera- 
tion may  have  withheld  vigorous  objection  because  of 
their  dependence  upon  other  functions  of  the  Federal 
Reserve.  On  the  other  hand,  some  of  the  larger  city  banks 
may  have  felt  it  impracticable  to  take  a  leading  part  in  the 


42  FEDERAL  RESERVE  POLICY 

agitation  for  the  spread  of  the  plan  for  fear  of  estranging 
the  country  banks  for  whom  they  wished  to  continue  to 
serve  as  city  agents.  In  point  of  numbers,  however,  it  is 
undoubtedly  true  that  the  decision  of  the  bankers  would 
be  decidedly  unfriendly.  At  least,  the  results  of  most 
referenda  indicate  general  hostility  toward  the  plan.  In 
one  such  referendum,  conducted  by  Mr.  Jerome  Thralls, 
of  the  Clearing  House  and  National  Banks  Sections  of  the 
American  Bankers'  Association,  more  than  three  fourths 
of  the  replies  gave  a  negative  answer  to  the  following  ques- 
tion: "Is  the  plan  of  clearing  and  check  collection  now 
operated  by  the  Federal  Reserve  banks  satisfactory  to 
you?"^  On  another  occasion  Governor  Harding,  of  the 
Federal  Reserve  Board,  admitted  that  probably  twenty 
thousand  out  of  twenty-four  thousand  acquiescing  banks 
had  agreed  to  the  system  unwillingly.^  Mr.  Harding  justi- 
fied the  plan  on  the  ground  that  it  represented  solely  the 
sincere  desire  to  administer  the  law.  If  relief  was  desired, 
he  insisted  that  pressure  should  be  brought  to  bear  upon 
the  legislative  branch  of  the  Government  and  not  upon  the 
Federal  Reserve  Board.  Stating  further  that  the  Board 
desired  to  clear  up  any  possible  vagueness  as  to  the  intent 
of  the  1-egislators,  he  even  suggested  the  terms  of  a  possible 
amendment  to  the  law  which  would  preserve  the  right  of 
exchange  deductions.^  This  attitude  of  Mr.  Harding, 
however,  can  be  reconciled  only  with  difficulty  with  his 
policy  at  the  time  of  legislative  consideration  of  the  Hard- 
wick  amendment.  Then  he  took  an  active,  and  not  merely 
passive,  position  of  hostility  to  the  terms  of  the  amendment 
suggested  by  the  exchange-charging  banks. 

Aside,  however,  from  the  popularity  of  the  par  collec- 
tion system  the  Board  has  met  with  remarkable  success  in 

'  See  Commercial  and  Fitiancial  Chronicle,  December  i6,  1916,  p.  2199. 

*  Cf.  ibid.,  May  15,  1920,  pp.  2034-36. 

*  See  Commercial  and  Financial  Chronicle,  May  15,  1920,  pp.  2036-37. 


CHECK  COLLECTIONS  AND  CLEARANCES      43 

its  endeavors  to  extend  the  scope  of  the  new  plan.  It  is 
true  that  at  first  much  difficulty  was  encountered.  In  the 
Federal  Reserve  Bulletin  for  February  i,  19 18,  we  read :  ^ 

Where  good  progress  has  been  made  it  has  been  almost  invar- 
iably due  to  energetic  solicitation  by  one  or  more  members  of 
the  staff  of  the  bank  who  have  devoted  their  attention  to  the 
matter  and  have  done  actual  work  for  the  purpose  of  adding  to 
their  par  list. 

Nevertheless,  on  February  15,  1922,  28,906  member  and 
non-member  institutions  were  on  the  par  list  and  only 
2,327  not  on  this  list.  On  this  date  every  bank  in  the  Bos- 
ton, New  York,  Philadelphia,  Chicago,  and  San  Francisco 
districts  was  a  member  of  the  clearing  system.  The  vol- 
ume of  work  accomplished  has  increased  enormously.  In 
the  month  January  16  to  February  15,  1922,  total  items 
handled  amounted  to  nearly  eleven  billions  of  dollars. 

It  has  been  suggested  previously  that  the  attitude  of 
business  in  its  desire  to  avoid  exchange  charges  has  been 
the  principal  support  of  the  reserve  banks  in  the  employ- 
ment of  their  coercive  measures.  Undoubtedly  much  of 
the  approval  of  business  in  the  early  days  was  due  to  the 
mistaken  belief  that  as  a  final  outcome  all  exchange 
charges  would  be  absolutely  eliminated.  As  previously 
indicated,  this  is  not  true.  There  is  now  legal  warrant  for 
the  exaction  from  the  public  of  certain  minimum  charges. 
While  on  the  whole  such  charges  are  less  than  in  the  old 
days,  there  are  numerous  exceptions  due  to  the  desire  of 
many  banks  to  make  up  in  charges  to  the  public  what  has 
been  lost  in  exactions  against  other  banks.  Thus  the 
Farmers  &  Merchants  National  Bank  of  Los  Angeles, 
California,  stated  in  its  monthly  letter  on  September  15, 
1916:^ 

'  Page  75. 

'  Extracts  from  this  letter  are  printed  in  the  Commercial  and  Financial  Chron- 
icle, September  23,  1916,  pp.  1083-84. 


44  FEDERAL  RESERVE  POLICY 

The  banks  on  the  Pacific  Coast,  for  instance,  have  heretofore 
accepted  Eastern  drafts  at  par.  They  recoup  themselves  by 
selling  exchanges  against  Eastern  funds  thus  obtained.  To-day, 
if  a  man  walks  into  a  Pacific  Coast  bank  with  a  draft  drawn  by 
a  solvent  party  on  an  Eastern  bank,  and  wants  immediate 
credit  for  the  proceeds  thereof,  he  will  be  compelled  to  pay  for 
the  use  of  the  money  until  the  bank  cashing  the  draft  has  re- 
ceived its  proceeds  from  the  party  upon  whom  it  is  drawn.  If  a 
merchant  deposits  out-of-town  items  and  gets  immediate  credit 
for  them,  he  will  be  compelled  to  pay  the  bank  with  whom  he 
makes  the  deposit  for  the  use  of  the  money  advanced  on  those 
items  until  the  bank  has  collected  them.  There  are  a  thousand 
and  one  services  which  banks  have  gratuitously  performed  for 
their  customers  that  they  will  now  charge  for. 

It  will  be  generally  agreed  that  such  practices,  if  not 
carried  to  undue  lengths,  are  as  they  should  be.  Nobody 
will  argue  that  the  bank  should  perform  such  services 
gratis.  Losses  encountered  in  one  operation  must  be  made 
up  in  others.  What  has  been  accomplished  under  the 
Federal  Reserve  has  been  to  place  the  various  services  of  a 
bank  on  such  a  basis  as  to  increase  the  likelihood  that  each 
will  carry  a  larger  portion  of  its  own  cost.  As  previously 
indicated,  the  aggregate  burden  borne  by  the  public 
should  be  considerably  reduced  under  the  new  plan.  No 
longer  need  so  many  deposits  be  maintained  at  various 
points  throughout  the  country  for  domestic  exchange  pur- 
poses. \No  longer  need  checks  be  indirectly  routed  with 
resulting  increases  in  clerical  and  postage  expense.  No 
longer  is  the  principal  clearance  work  of  the  country  per- 
formed entirely  by  unrelated  and  uncoordinated  clearing 
organizations.  These  economies  should  redound  ultimately 
to  the  benefit  of  the  public. 

In  order  that  the  reserve  banks  should  function  satis- 
factorily as  the  correspondent  banks  of  the  members,  it 
soon  became  necessary  that  they  handle  other  items  than 
bank  checks.  It  would  have  worked  a  hardship  to  require 


CHECK  COLLECTIONS  AND  CLEARANCES      45 

member  banks  to  maintain  balances  with  city  correspond- 
ents in  addition  to  those  with  reserve  banks.  Accordingly 
in  the  Bulletin  for  September  i,  1917,'  we  read  that  the 
Board  requests  the  various  reserve  banks  to  establish 
collection  departments  for  time  items.  At  the  present 
time  the  reserve  system  handles,  in  cases  where  satisfac- 
tory arrangements  exist  for  collecting  checks,  such  items 
as  promissory  notes,  trade  bills,  trade  drafts,  coupons  and 
acceptances.  This  extension  of  the  reserve  activities  was 
necessary  if  the  reserve  banks  were  to  be  effective  substi- 
tutes for  the  former  reserve  agents  of  member  banks. 

The  growth  in  this  collection  work  has  necessitated  a 
considerable  enlargement  of  the  functions  of  the  Gold 
Settlement  Fund.  Prior  to  the  development  of  the  inter- 
district  system  it  was  employed  largely  to  handle  transfers 
or  drawings  between  reserve  banks.  Later  it  became  the 
means  by  which  individual  banks  could  be  benefited 
directly.  Transfers  originating  with  one  member  bank 
can  be  made  in  the  interest  of  another  member  bank  of 
another  district.  In  the  course  of  its  development  it  be- 
came the  agency  by  which  transfers  could  be  made  on  note 
accounts  between  the  Federal  Reserve  agents  and  the 
reserve  banks  which  they  represent.  Finally  it  became 
the  clearance  fund  for  the  inter-district  collection  system. 
It  is  impossible  to  stress  too  highly  its  functions  in  ena- 
bling to  run  smoothly  the  machinery  of  domestic  exchange. 

What  now  shall  be  our  conclusions  regarding  the  merits 
of  the  par  collections  controversy?  Shall  we  take  the  posi- 
tion that  because  of  its  economy  and  efficiency  its  further 
progress  should  not  be  impeded?  Or  should  we  conclude 
that,  while  an  economy  may  have  been  wrought  for  the 
banks  as  a  whole,  it  has  discriminated  unfairly  against  the 
small  country  bank? 

'  Page  661. 


46  FEDERAL  RESERVE  POLICY 

It  is  clear,  first  of  all,  that  the  law  does  not  prevent  the 
country  bank  from  levying  upon  the  depositor  of  a  check 
drawn  upon  a  foreign  bank.  Some  banks,  however,  receive 
fewer  checks  drawn  upon  foreign  banks  than  are  presented 
to  them  for  collection.  Such  charges  may  not  be  sufficient 
to  overcome  the  loss  due  to  the  necessity  of  remitting  for 
its  own  checks  at  par.  If  this  be  the  situation,  then,  why 
not  levy  upon  the  depositor  who  sends  a  check  to  a  distant 
point  and  thereby  imposes  upon  the  bank  the  burden  of 
providing  remittance? 

It  is  obvious  that  much  friction  would  be  created  if  any 
such  per-item  expense  were  imposed.  The  necessity  of 
such  a  charge  would  not  be  understood  generally,  and 
banking  has  so  developed  that  the  depositor  has  come  to 
feel  it  his  innate  right  to  emit  checks  drawn  against  his 
account  to  any  distant  point.  As  a  matter  of  business 
policy  the  country  bank  cannot  recoup  in  this  manner. 
But  there  still  remains  the  possibility  of  recouping  in- 
directly. Cannot  the  depositor  be  required  to  maintain  a 
larger  average  balance?  If  not  this,  cannot  it  be  recog- 
nized that,  since  former  collection  profits  are  lost,  the  inter- 
est charge  on  the  original  loan  must  be  permitted  to  adjust 
itself  to  a  higher  point? 

Much  can  be  said  in  behalf  of  the  method  of  requiring 
larger  minimum  balances.  Many  accounts  are  unprofit- 
able; should  not  the  country  as  well  as  the  city  bank  en- 
deavor to  refrain  from  doing  any  portion  of  business  at  a 
distinct  loss?  The  balance  idea,  moreover,  would  prove 
helpful  in  other  connections,  such  as  to  render  it  more 
difficult  to  overdraw  accounts,  and  to  preserve  for  the 
bank  funds  the  depositor  does  not  require  in  his  period  of 
slack  business.^  The  only  objections  to  such  methods  would 

*  The  balance  idea  tends  to  encourage  a  borrower  to  keep,  in  his  slack  season, 
as  large  balances  as  possible  in  order  that  the  yearly  average  may  be  high. 


CHECK  COLLECTIONS  AND  CLEARANCES      47 

be  the  difficulties  of  introducing  new  and  unwelcome 
methods  into  a  competitive  situation  where  old  customs 
have  had  time  to  harden. 

But  are  these  objections  sufficient  to  warrant  the  resto- 
ration of  the  old  custom  of  permitting  deductions  against 
the  foreign  bank  of  deposit?  Should  the  Federal  Reserve 
Act  be  so  amended  as  to  permit  reasonable  charges  to  be 
levied  against  the  collection  agents  of  the  banks  of  deposit, 
the  reserve  banks? 

Many  difficulties  to  such  a  solution  appear  immediately. 
A  charge  against  the  reserve  bank  is  an  indirect  charge 
against  its  member  banks. ^  Why  should  the  reserve  bank 
lessen  the  earnings  available  for  the  group  in  order  that 
the  drawee  bank,  which  may  not  even  be  a  member  of  the 
reserve  system,  may  have  its  checks  cleared  without  cost 
and  possibly  at  a  profit?  Why  should  the  bank,  member 
or  non-member,  whose  checks  are  distributed  in  largest 
volume  in  distant  communities,  derive  extra  commissions 
as  against  banks  which  have  not  created  so  much  work 
and  expense  for  outside  collection  agencies?  Is  not  the 
reserve  bank  already  rendering  in  direct  as  well  as  indirect 
ways,  a  sufficiency  of  free  services  for  the  non-member 
banks  of  the  country?  Will  not  the  proper  regulation  of 
the  reserve  system  prove  all  the  more  difficult  if  the  twelve 
reserve  banks  are  put  under  added  pressure  to  earn  at  all 
times  sufficient  to  offset  these  and  similar  costs? 

Answers  to  these  queries  are  not  promising:  With  the 
change  in  old  methods,  the  substitution  of  reserve  banks 
for  independent  private  banks  as  reserve  agents,  there  is 
no  longer  the  same  justification  for  the  imposition  of  large 
charges  against  the  collecting  bank.  The  solution  for  the 
country  exchange-charging  bank  must  be  found  in  re- 

'  The  member  banks  are  the  stockholders  of  the  reserve  banks.  Of  course,  the 
burden  would  be  torne  by  the  Government  if  the  earnings  were  more  than 
sufficient  to  meet  the  minimum  amount  permitted  for  stockholders. 


48  FEDERAL  RESERVE  POLICY 

couping  from  the  depositors  of  foreign  items,  by  direct 
exchange  charges  imposed  upon  the  public,  by  requesting 
offsetting  balances  from  customers  who  demand  the  right 
to  circulate  checks  outside  the  neighborhood  of  their 
banks,  or  by  permitting  the  original  discount  rate  to 
adjust  itself  so  as  to  compensate  for  the  loss. 

In  a  rather  marked  manner  the  par  collections  contro- 
versy recalls  the  old  contest  for  sound  banking  methods 
in  the  wild-cat  days  prior  to  the  Civil  War.  Then  banks 
customarily  refused  to  meet  willingly  their  obligations  at 
par.  Then  they  sought  court  action  to  avoid  payment  in 
full  of  their  obligations.  Then  they  endeavored  to  prevent 
the  development  of  a  system  whereby  the  parity  of  all  the 
elements  in  the  currency  system  could  be  maintained. 
Then,  however,  the  controversy  had  to  do  with  bank  notes 
and  not  with  checks.  But  the  checks  of  to-day  occupy  the 
place  of  the  note  issues  of  yesterday.  Issues  of  banks  pay- 
able to  bearer  are  becoming  relatively  less  important. 
More  and  more  their  position  is  being  occupied  by  checks. 

A  temporary  loss  of  profit  to  a  portion  of  the  banks 
should  not  be  permitted  to  impede  the  development  of  the 
system  of  par  collections.  Undoubtedly  some  banks  have 
a  grievance.  In  some  cases  the  reserve  ofificials  may  have 
displayed  an  excess  of  zeal  in  their  coercive  measures.  It 
may  have  been  true  that  the  reserve  administration  has 
not  always  been  absolutely  sincere  in  its  defense  of  its  own 
course  of  action.  In  many  instances  its  interpretation  of 
the  law  was  not  the  only  reasonable  one ;  in  other  instarwzes 
reserve  ofificials  advertised  their  own  indifference  to  the 
terms  of  the  law  and  insisted  their  function  was  solely  to 
administer  the  statute  as  bequeathed  to  them  by  law- 
makers, while  at  the  same  time  they  were  exerting  every 
endeavor  to  prevent  a  legislative  change.  Nevertheless, 
the  writer  believes  that  in  the  par  collections  controversy 


CHECK  COLLECTIONS  AND  CLEARANCES      49 

the  Board  has  displayed  rare  good  tact  in  coordinating 
concession  and  firmness;  that,  in  so  far  as  it  has  possessed 
discretionary  power,  it  has  employed  it  solely  for  the  pur- 
pose of  correcting  former  abuses  in  our  methods  of  domes- 
tic exchange. 


CHAPTER  III 

STATE  BANK  MEMBERSHIP  IN  THE  FEDERAL 
RESERVE 

At  the  time  of  the  framing  of  the  Federal  Reserve  Act  few 
problems  presented  more  difficulties  than  those  relating 
to  the  requirements  for  admission  into  the  new  system. 
A  priori  the  weight  of  advantage  seemed  to  lie  on  the  side 
of  a  large  membership.  Not  only  would  a  small  member- 
ship mean  that  the  resources  of  the  reserve  banks  would 
be  small,  but  also  that  a  large  number  of  banks,  by  remain- 
ing outside  the  system,  would  not  be  affected  directly  by 
the  policies  of  the  reserve  administration.  In  its  open 
market,  or  purchase  operations,  a  reserve  system  of  limited 
membership  would  not  have  the  funds  to  exercise  any 
large  measure  of  control  over  the  money  market  by  com- 
peting with  private^institutions.  In  its  rediscount  opera- 
tions few  banks  would  be  dependent  upon  the  reserve  and, 
accordingly,  capable  of  being  affected  by  the  rate  policy 
of  the  Federal  Reserve  Board. 

On  the  other  hand,  however,  it  was  generally  agreed 
that  it  would  be  a  mistake,  perhaps  irretrievable,  to  make 
in  the  beginning  too  many  concessions  in  order  to  secure 
the  entrance  of  a  large  number  of  banks.  The  assets  of  the 
reserve  banks  would  consist  largely  of  paper  endorsed  by 
member  banks.  Should  this  paper  prove  to  be  of  inferior 
quality,  the  resources  of  the  reserve  system  must  be 
impaired.  The  character  of  the  reser\'e  management, 
furthermore,  must  depend  largely  upon  the  member  insti- 
tutions.  Out  of  the  nine  district  directors  six  were  to  be 


STATE  BANK  MEMBERSHIP  51 

chosen  by  the  member  banks.  The  importance  of  an  able 
membership  in  the  district  directorates  was  clear  to  all. 
It  could  not  be  expected  that  the  Federal  Reserve  Board 
could  concern  itself  greatly  with  the  detailed  application 
of  its  policies  to  individual  cases.  Such  duties  must  de- 
volve largely  upon  the  district  directorates.  Too  great 
liberality  as  regards  membership  might  also  produce 
unfortunate  results  outside  the  system.  In  the  attempt  to 
maintain  a  place  for  State  non-member  banks,  State  legis- 
latures might  lessen  the  strictness  of  banking  laws,  and 
thus  create  an  unhealthy  situation  in  which  the  State  and 
the  Nation  would  be  obliged  to  compete  one  with  another 
for  more  lax,  rather  than  for  more  sound,  conditions  of 
bank  control.  Subsequent  history  furnishes  some  con- 
firmation as  to  the  correctness  of  this  fear.  From  the 
Report  of  the  Federal  Reserve  Board  for  the  year  191 5'' 
we  read  that  some  States  had  lowered  reserve  requirements 
materially  since  the  adoption  of  the  Federal  Reserve  in 
order  to  enable  non-member  institutions  to  compete  more 
effectively  with  the  members. 

It  was  understood  also  that  early  mistakes  in  the  direc- 
tion of  excessive  conservatism  could  be  corrected  more 
easily  than  those  of  excessive  liberality.  It  is  easier  to 
grant  concessions  than  to  employ  new  measures  of  control. 
Since,  in  all  probability,  the  reserve  framework  must  be 
altered  after  some  years  of  experience,  it  appeared  prefer- 
able to  build  a  small  superstructure  on  a  sound  foundation 
rather  than  a  lofty  though  shaky  banking  house  upon 
imperfect  supports. 

Too  great  strictness  in  the  beginning,  however,  might 
defeat  the  purpose  of  the  lawmakers.  If  the  reserve  insti- 
tutions should  not  display  at  an  early  date  the  strength 
which  comes  from  a  large  membership,  popular  faith,  and 

'  Page  13. 


52  FEDERAL  RESERVE  POLICY 

accordingly  popular  support  for  the  new  banking  system 
might  disappear.  It  is  therefore  easy  to  understand  the 
difficulties  of  applying  the  preceding  general  observations 
to  the  specific  facts  of  initial  organization. 

Over  a  portion  of  the  banks  of  the  country,  the  national 
banks,  the  Federal  lawmakers  possessed  mandatory  power. 
.  The  only  alternative  to  membership  for  these  institutions 
would  be  the  surrender  of  their  national  charters.  Since, 
furthermore,  it  was  expected  that  most  of  these  banks 
would  discern  the  helpful  possibilities  of  the  system,  the 
strict  provisions  were  inserted  in  the  law  that  any  national 
bank  failing  to  signify  its  acceptance  of  the  terms  of  the 
act  within  sixty  days  after  proper  notification  to  subscribe 
to  the  stock  of  its  district  reserve  bank  must  cease  to  act 
as  a  reserve  agent.  If  within  one  year  after  the  passage  of 
the  act  it  failed  to  comply  with  the  provisions  of  the  act, 
it  must  forfeit  its  Federal  charter.  During  the  days  of 
organization,  many  insinuations  were  current  regarding 
the  refusal  of  some  of  the  country's  most  powerful  na- 
tional banking  institutions  to  accept  these  terms.  But  it 
finally  appeared  that  in  many  cases  the  motive  for  these 
veiled  threats  represented  pressure  to  secure  more  favor- 
able terms  in  the  act  or  the  endeavor  of  some  of  the  banks 
which  favored  the  bill  to  get  the  public  in  the  correct 
psychological  attitude  for  sanctioning  the  plan.  It  may  well 
be  that  after  the  experience  with  the  Aldrich  plan,  a  scheme 
interpreted  primarily  as  a  measure  of  public  control  or 
public  coercion  would  enlist  popular  support  more  easily. 
Over  the  State  banks,  however,  direct  power  of  control 
was  lacking.  To  secure  their  admission  permissive  and 
not  mandatory  provisions  were  inserted  in  the  act.  The 
more  important  conditions  of  membership  for  these  banks 
were  the  following:* 

»  See  section  9  of  the  original  act. 


STATE  BANK  MEMBERSHIP  53 

(a)  First,  they  must  comply  with  the  requirements 
relating  to  capital  and  reserves  imposed  by  law  upon 
national  banks.  Laws  relating  to  national  banks  prohibit- 
ing the  purchase  of  or  loans  upon  their  capital  stock,  the 
withdrawal  of  capital,  or  its  dissipation  through  payment 
of  unearned  dividends,  must  also  apply  to  State  member 
banks.  Their  capital,  furthermore,  must  be  such  as  to 
entitle  them  to  become  national  banking  associations 
according  to  the  population  of  the  place  in  which  they  were 
situated. 

(b)  Secondly,  they  must  submit  to  examinations  and 
regulations  prescribed  by  the  Federal  Reserve  Board,  and 
must  make  certain  reports  of  dividends  to  the  Comptroller 
of  the  Currency.  In  the  event  of  failure  to  comply  with 
the  terms  of  the  act  or  with  the  regulations  of  the  Reserve 
Board,  they  could  be  required  to  surrender  their  stock  in 
the  reserve  bank. 

(c)  In  the  third  place,  the  banks  must  conform  to  the 
provisions  of  law  imposed  on  national  banks  "respecting 
the  limitation  of  liability  which  may  be  incurred  by  any 
person,  firm,  or  corporation  to  such  banks." 

These  were  the  pertinent  provisions  of  the  law.  What 
has  been  their  effect  upon  the  entrance  of  State  banks. 
Historically,  State  admissions  may  be  classified  as  falling 
into  two  periods:  first,  the  period  succeeding  organization 
to  June  21,  191 7;  second,  that  which  followed  the  summer 
of  191 7.  Let  us  first  consider  the  State  admissions  in  the 
early  period. 

On  June  27,  1914,  it  was  announced  that  only  fifty  State 
banks  had  made  application  for  membership.'  In  the 
Report  of  the  Federal  Reserve  Board  for  the  year  191 4  we 
read : "" 

•  See  news  item  in  the  Commercial  and  Financial  Chronicle,  July  4,  1914, 
p.  16.  The  Federal  Reserve  Bulletin  was  not  published  until  May  I,  1915. 
'  Page  20. 


54  FEDERAL  RESERVE  POLICY 

Since  the  passage  of  the  Federal  reserve  act,  there  have  been 
converted  into  National  banks  93  State  banks  and  trust  com- 
panies, with  a  capital  and  surplus  of  $9,151,306.  There  have 
been  admitted  to  the  system  as  members  thereof  9  State  banks 
and  4  trust  companies,  the  aggregate  capital  and  surplus  of  the 
13  institutions  being  $17,884,000.  Those  State  institutions 
which  have  already  been  admitted  to  the  system  have  entered 
upon  the  understanding  that  they  are  to  accept  any  regulations 
the  Board  may  make  regarding  the  conduct  of  member  banks. 
There  are  pending  at  the  present  time  51  State  banks  and  trust 
companies.  These  applicants  have  preferred  to  await  the 
issuance  of  regulations  governing  the  admission  of  State  banks. 

Three  years  later,  June  21,  19 17,  53  State  banks  and 
trust  companies  with  aggregate  capital  and  surplus  of 
^78,491,165  and  resources  of  ^825,000,000  were  members.' 
In  view  of  the  infinitely  larger  number  and  resources  of  the 
non-member  institutions,  it  appears  in  this  first  period 
that  the  conditions  of  membership  were  not  appealing  to 
the  great  body  of  State  institutions. 

To  what  facts  shall  we  attribute  this  unwillingness  to 
join.  Would  it  not  appear  that  the  statutory  provisions 
regarding  eligibility  were  extremely  liberal?  Were  not  the 
general  terms  of  the  act  such  as  to  render  attractive  mem- 
bership for  the  typical  country  institutions?  For  one  mat- 
ter, small  institutions  could  not  object  seriously  to  the 
method  of  selecting  district  directors.  The  method 
adopted  was  specially  devised  to  ensure  representation  for 
the  smaller  banks.  Legal  reserve  requirements,  further- 
more, were  reduced  by  the  act  for  all  member  institutions.^ 
The  statute  also  contained  no  prohibitory  measure  regard- 
ing loans  on  real  estate.  The  regulations  of  the  Board 
regarding  real  estate  loans  were  liberal,  merely  requiring 
that  they  be  not  carried  in  such  liberal  amounts  as  to 

'  Cf.  Report  of  the  Federal  Reserve  Board  for  the  year  1917,  p.  14. 
'  If  State  laws  should  impose  higher  requirements,  these  would  govern  banks 
chartered  by  the  State. 


STATE  BANK  MEMBERSHIP  55 

impair  the  general  liquidity  of  the  bank's  assets.  In  view 
of  the  great  reliance  of  many  state  banks  upon  real  estate 
loans,  the  generosity  of  these  provisions  was  of  great  im- 
portance. 

First  among  the  reasons  explanatory  of  the  refusal  of 
the  great  number  of  State  banks  to  pay  the  price  required 
to  share  in  the  benefits  of  the  organization  was  the  doubt- 
ful legal  position  of  the  applying  bank.  Regarding  this 
matter  the  following  news  item  published  in  the  Commer- 
cial and  Financial  Chronicle  for  July  4,  1914,  is  pertinent:  ^ 

Advices  from  the  Organization  Committee  state  that  there 
are  only  twenty  States  in  which  the  Treasury  Department 
officials  are  sure  that  it  is  possible  for  State  banking  institutions 
to  become  members  of  the  new  Federal  reserve  system  without 
some  modification  of  the  laws.  These  States  are  Vermont, 
New  York,  New  Jersey,  Delaware,  Maryland,  Virginia,  West 
Virginia,  Kentucky,  Tennessee,  Ohio,  Indiana,  Illinois,  South 
Carolina,  Alabama,  Mississippi,  Arkansas,  Texas,  Arizona, 
California,  and  Oregon.  Two  of  these  States  —  Kentucky  and 
South  Carolina  —  passed  enabling  acts  since  the  passage  of 
the  Federal  Reserve  Act  which  make  it  possible  for  the  State 
banks  and  trust  companies  to  enter  the  Federal  reserve  bank 
system.  In  New  Mexico  and  Montana  it  is  possible  for  trust 
companies,  but  not  for  State  banks,  to  become  member  banks 
of  Federal  reserve  banks.  The  information  of  the  Reserve 
Bank  Organization  Committee  is  based  largely,  it  is  said,  on 
letters  written  by  State  officials  in  reply  to  inquiries  concerning 
their  State  laws  and  the  necessity  for  amendment  of  their 
statutes,  so  that  their  financial  institutions  may  participate  in 
the  new  system.  Without  exception,  it  is  added,  the  State  offi- 
cials gave  assurance  that  steps  would  be  taken  to  make  changes 
in  State  laws  which  will  enable  State  banks  to  join  the  Federal 
reserve  banks,  if  they  so  desire.  However,  in  many  States  the 
legislatures  do  not  convene  until  1915. 

Gradually,  however,  the  necessary  legislation  was  en- 
acted in  most  States  and  difficulty  on  this  score  largely 

'  Page  16. 


56  FEDERAL  RESERVE  POLICY 

removed.  But  the  delay  thus  enforced  may  have  caused 
some  State  banks,  whose  enthusiasm  was  aroused  in  the 
beginning,  to  postpone  appHcation  at  a  time  when  interest 
in  banking  reform  was  the  most  intense.  With  each  day  of 
delay  the  general  attitude  became  more  and  more  one  of 
indifference.  The  money  market  was  easy  in  the  first  few 
years  succeeding  1914  and  the  need  did  not  appear  for  any 
great  reliance  upon  the  Federal  Reserve.  In  the  interval 
during  which  the  permissive  legislation  was  being  framed, 
State  bankers  had  ample  opportunity  to  study  the  terms 
of  the  statute  and  analyze  its  apparent  defects.  Some  of 
the  resulting  objections  were  sound  and  some  were  un- 
sound. But  attitude  toward  membership  was  primarily  a 
matter  of  the  bankers'  beliefs  and  only  secondarily  a  mat- 
ter of  the  financial  soundness  of  their  views. 

Among  the  most  emphasized  of  difficulties  was  the  fear 
that  membership  would  subject  State  banks  to  many 
prohibitions  applying  to  national  banks  even  though  these 
prohibitions  were  not  contained  in  the  Federal  Reserve 
Act.  For  instance,  it  was  asserted  frequently  that  mem- 
bership would  subject  the  shareholders  to  double  liability 
in  the  event  of  insolvency,  even  though  the  law  in  the 
State  of  incorporation  did  not  impose  such  requirements. 
This  fear,  however,  was  soon  dispelled  by  the  publication 
of  an  Opinion  of  Counsel  in  the  September  i,  19 15,  issue  of 
the  Federal  Reserve  Bulletin,'^  in  which  it  was  held  that  this 
provision  of  national  banking  law  was  not  applicable  to 
State  banks.  The  only  double  liability  resulting  from 
membership  in  the  Federal  Reserv^e  Act  was  that  pertain- 
ing to  the  stock  subscriptions  in  the  reserve  banks.  Liabil- 
ity of  shareholders  on  this  account  would  be  small.  Of 
course,  State  member  banks  would  be  subject  to  the  regu- 
lations of  the  Reserve  Board.   But  these  regulations  must 

'  Page  273. 


STATE  BANK  MEMBERSHIP  57 

be  based  upon,  rather  than  in  conflict  with,  statutory  law. 

But  aside  from  restrictions  and  limitations  of  powers, 
what  about  the  advantages  of  membership?  Would  the 
rediscounting  privilege  in  particular  be  of  any  great  benefit 
to  the  great  number  of  State  banks?  ]VIore  specifically 
would  State  banks  possess  much  of  the  paper  eligible  for 
rediscount?  In  the  days  of  organization  there  was  current 
a  general  belief  that  the  Board  would  require  financial 
statements  of  the  maker  of  the  paper  to  accompany  redis- 
count applications.  In  its  first  regulations  such  conditions 
were  imposed  as  a  basis  for  ultimate  procedure.  But  small 
banks  ordinarily  do  not  need  to  require,  and  often  are  not 
in  a  position  to  demand,  such  statements.  It  is  not  strange, 
therefore,  that  in  a  referendum  conducted  by  the  Bankers* 
Information  Ser\ace  of  Washington  *  the  consensus  of 
opinion  was: 

That  although  they  will  be  compelled  to  pay  a  portion  of 
their  capital  into  the  capital  of  the  Federal  Reserve  System, 
where  it  will  be  tied  up,  they  may  receive  no  benefit  because  the 
class  of  commercial  paper  they  handle  is  not  eligible  for  dis- 
count under  the  regulations  of  the  Federal  Reserve  Board. 

Expressing  the  same  prevalent  view,  also,  was  the  follow- 
ing editorial  extract  from  the  Commercial  and  Fitiancial 
Chronicle:  * 

Manifestly,  since  the  regional  Reserve  bank  is  made  up  out 
of  the  stock  contributions  of  all  the  banks  large  and  small, 
nationals,  proportionate  to  their  stock  and  surplus,  the  benefits 
of  the  system  should  inhere  to  each  in  like  manner,  and  the 
access  for  rediscount  should  be  free  to  all.  Yet  we  find  that  the 
status  of  the  large  bank  and  the  small,  or  the  country  bank,  is 
reversed  by  the  provisions  governing  rediscount.  Formerly  it 
was  the  country  bank  that  rediscounted  its  paper  most  freely, 
the  large  central  institutions  rediscounting  very  little  and  that 
against  principle.   Now,  such  are  the  provisions  governing  that 

'  Cf.  Commercial  and  Financuil  Chronicle,  March  27,  1915,  p.  1047. 
'  Issue  of  January  20,  1917,  p.  197. 


58  FEDERAL  RESERVE  POLICY 

kind  of  paper  admissible,  the  city  bank  is  meant  to  be,  and  can 
be,  the  easy  and  extensive  borrower  at  the  Federal  Reserve 
Bank,  while  the  country  bank  finds  it  extremely  difficult  to 
come  within  the  provisions,  owing  to  the  nature  of  its  local 
business,  and  is,  in  fact,  scarcely  at  all  a  borrower  from  the  said 
bank. 

As  a  matter  of  subsequent  history  such  fears  do  not 
appear  to  have  been  justified.  In  later  chapters  evidence 
will  be  presented  that  the  reserve  administration  went  the 
limit  of  liberality  in  its  endeavors  to  make  the  reserve 
banks  useful  to  all  classes  of  institutions.  Requirements 
concerning  the  filing  of  financial  statements  were  altered 
early  in  191 5  so  as  to  constitute  virtually  no  bar  to  the 
applying  member  bank.  The  testimony  of  reserve  bank 
directors  has  been  almost  unanimous  that  where  the  re- 
serve bank  was  permitted  to  cooperate,  it  was  found  the 
member  bank's  portfolio  contained  much  paper,  either 
directly  admissible,  or  of  such  a  character  as  to  enable  it 
easily  to  be  made  eligible.  Confirmatory  of  such  a  view 
are  the  following  remarks  of  Governor  Strong,  of  the  New 
York  Reserve  Bank,  before  a  group  of  the  New  York  State 
Bankers'  Association :  * 

The  statement  has  also  been  made  by  some  bankers  of  our 
district  that  very  little,  if  any,  of  the  paper  held  by  their  banks 
is  eligible  for  rediscount  with  the  Federal  Reserve  Bank.  Those 
bankers  who  make  this  statement  are  liable  to  create  the  impres- 
sion that  this  opinion  is  held  generally  by  member  banks;  but 
an  examination  of  statements  filed  with  us  disclosed  that  only 
about  80  banks,  out  of  our  480  members,  reported  that  they 
had  very  little,  if  any,  paper  eligible  for  rediscount.  With  these, 
we  have  communicated,  in  order  to  ascertain  upon  what  theory 
their  reports  were  based.  By  correspondence  and  personal 
interview,  with  many  of  them,  we  have  satisfied  them,  as  well 
as  ourselves,  that  one  half  or  more  of  the  paper  they  hold  is 
eligible  for  rediscount. 

'  A  part  of  this  address  is  printed  in  the  Commercial  and  Financial  Chronicle, 
June  5,  1915,  p.  i88o. 


STATE  BANK  MEMBERSHIP  59 

Such  condusions  as  these  represented  the  usual  results  of 
investigation  in  other  districts. 

In  the  rare  cases  where  no  eligible  paper  existed,  the 
resources  of  the  reserve  bank  might  furnish  indirect  aid. 
The  needy  member  bank  might  borrow  on  its  note  pay- 
able from  another  member  bank  which  did  possess  eligible 
paper.  Furthermore,  eligible  paper  might  be  purchased 
from  commercial  paper  houses  or  from  other  banks.  Such 
paper,  rediscounted,  would  increase  the  reserve  of  the  bor- 
rowing institution;  while,  if  arrangements  could  be  made 
whereby  the  seller  would  obtain  for  the  time  being  only  a 
credit  upon  the  bank's  books,  payment  for  this  paper  need 
not  mean  an  immediate  and  corresponding  loss  in  cash  or 
reserve  money. 

The  above  arguments  were  addressed  to  the  State  banks 
however,  largely  from  the  point  of  view  of  their  collective 
strength  and  not  that  of  individual  profit.  From  the  stand- 
point of  its  own  individual  gain  the  necessity  was  not 
always  clear  for  joining  a  set  of  rediscount  institutions 
whose  funds  should  be  husbanded  carefully  for  emergen- 
cies. From  a  selfish  viewpoint  many  a  bank  might  reason 
that  the  reserve  system  might  be  maintained  by  other 
institutions;  that  so  far  as  it  required  rediscount  aid,  it 
could  rely  upon  its  old  city  correspondents,  who  in  turn 
could  secure  aid  from  the  reserve  banks.  With  such  insti- 
tutions it  had  in  the  past  maintained  occasional  redis- 
count relations,  and  it  appeared  easier  to  continue  these 
old  customs  than  to  take  the  trouble  of  investigating  redis- 
count regulations  applicable  to  the  new  reserve  banking 
system.  Particularly  likely  was  such  a  position  to  be  taken 
at  a  time  of  great  ease  in  the  money  market. 

In  other  situations  it  was  not  so  much  a  matter  of  inabil- 
ity to  ascertain  the  advantages  of  mcmbcrsliij),  but  rather 
a  belief  that  admission  would  involve  direct  disadvantcigcs. 


6o  FEDERAL  RESERVE  POLICY 

In  this  connection  discussions  of  systems  of  check  clear- 
ances assumed  much  importance.  Would  the  reserve 
banks  develop  clearing  departments  which  would  remove 
the  necessity  of  depending  upon  outside  city  correspond- 
ents? The  law  gave  discretionary  power  to  the  Reserve 
Board  to  require  reserve  banks  to  act  as  clearing  agencies, 
but  did  not  make  this  function  mandatory.  If  this  service 
was  not  certain  to  be  developed,  membership  might  prove 
costly.  In  addition  to  deposits  with  reserve  banks,  ac- 
counts with  city  correspondents  for  clearance  purposes 
might  continue  to  be  necessary.  There  was  no  probability 
that  city  banks  would  discontinue  bidding  for  country 
bank  deposits.  As  long  as  they  paid  interest  on  bankers' 
deposits  it  would  seem  preferable  to  maintain  deposits 
with  them  than  with  the  reserve  banks  which  paid  no 
interest. 

But  even  if  the  reserve  banks  should  make  provision  for 
clearances,  it  was  not  certain  that  the  new  facilities  would 
offer  any  economies  in  making  collections.  What  if  the 
reserve  banks  should  refuse  to  clear  checks  drawn  on  non- 
member  institutions?  Unless  checks  on  both  classes  of 
banks  were  to  be  cleared,  members  might  be  obliged  to 
maintain  balances  with  city  correspondents  for  the  collec- 
tion of  non-member  bank  items  in  addition  to  those 
deposited  with  reserve  banks. 

There  was  also  uncertainty  about  the  future  rights  of 
banks  to  deduct  exchange  on  remittances  for  their  own 
checks.  As  indicated  previously,  such  charges  constituted 
a  large  part  of  the  profits  of  some  of  the  smaller  institu- 
tions and  the  prevailing  custom  was  one  working  in  favor 
of  the  country  bank.  In  the  early  stages  of  the  bill  in  Con- 
gress, the  provision  prohibiting  these  exchange  deductions 
proved  very  shocking  to  these  banks.  Although  this  objec- 
tionable provision  was  modified  later,  it  was  doubtful 


STATE  BANK  MEMBERSHIP  6i 

whether  the  rigkts  of  country  banks  as  determined  by 
established  custom  was  sufficiently  safeguarded.  The  con- 
cessions granted  to  them  in  the  final  draft  of  the  bill  pre- 
served their  rights  to  deduct  exchange  only  to  the  extent 
that  costs  were  incurred  in  collection  and  remittance.  It 
was  foreseen  by  some  that  it  was  within  the  province  of 
possibilities  for  the  reserve  collection  system  to  develop  in 
such  a  way  as  to  eliminate  all  costs  incurred  in  remittance. 
Would  not  the  presentation  of  checks  at  the  counter  de- 
stroy *  the  justification  for  such  charges?  If  so,  would  it  not 
be  better  to  refrain  from  adding  to  the  resources  and 
thereby  to  increase  the  prestige  of  the  reserve  system  until 
definite  guarantees  were  given  regarding  the  right  to  con- 
tinue to  impose  such  charges? 

On  what  terms  also  could  State  member  banks  withdraw 
from  the  system?  Since  the  days  of  Andrew  Jackson  no 
American  bank  had  had  any  experience  with  such  a  bank- 
ing system.  The  success  of  the  Federal  Reserve  was  prob- 
lematical. Its  future  relations  to  member  banks  must 
depend  largely  upon  its  management.  It  might  become  a 
helpful  organization  securing  for  our  banking  system  a 
stability  never  before  possessed.  On  the  other  hand,  it 
might  become  the  "monster"  of  the  time  of  the  Second 
United  States  Bank.  If  so,  could  an  early  mistake  in 
becoming  a  member  be  corrected  easily?  Must  withdrawal 
necessitate  voluntary  liquidation? 

Particularly  important  were  such  questions  to  those 
State  banks  which  were  performing  functions  not  legal 
for  member  national  banks.  If,  after  membership,  such 
functions  were  being  exercised,  would  inability  to  with- 
draw necessitate  the  abandonment  of  that  kind  of  business? 
It  is  true  that  in  its  early  regulations  the  Board  endeavored 
to  calm  the  fears  of  the  banks  by  making  such  withdrawals 

'  See  supra,  pp.  34-37. 


62  FEDERAL  RESERVE  POLICY 

easily  possible.  But  the  Federal  Reserve  Board  was  a 
body,  not  with  a  permanent,  but  rather  with  a  shifting 
personnel.  In  the  course  of  time,  because  of  a  change 
either  in  viewpoint  or  membership,  its  regulations  might 
be  altered.  Regulations,  alone,  did  not  seem  to  provide  a 
sufficient  safeguard. 

Provisions  regarding  examinations  were  also  distasteful 
to  many  State  banks.  By  the  terms  of  the  statute  certain 
powers  of  examination  were  conferred  upon  the  Federal 
Reserve  Board,  and  the  Comptroller  of  the  Currency  had 
the  right  to  require  statements  of  condition  and  operation. 
These  powers  of  examination  and  inquiry  were  to  be  added 
to  those  possessed  by  the  State  Banking  Department  and 
mayhap  also  to  those  of  the  local  clearing  house.  An 
excess  of  examination  was  easily  possible.  Not  merely 
might  this  involve  much  loss  of  time  to  the  officers  and 
clerical  staff  of  the  bank,  but  examination  is  always  unwel- 
come because  of  the  possibility  of  bank  secrets  being 
spread  in  this  way.  It  would  be  much  more  difficult  to 
trace  the  origin  of  such  disclosures  when  examinations 
could  be  conducted  by  so  many  differently  constituted 
bodies. 

In  order  to  quiet  discontent  on  this  score,  the  Board 
made  every  feasible  concession.  Particularly,  since  every 
bank  was  to  be  contingently  liable  for  its  rediscounted 
paper,  and  because  neither  the  Board  nor  the  district  di- 
rectorate could  be  expected  to  make  careful  investigations 
of  the  credit  standing  of  the  original  borrower  in  all  cases, 
it  was  unwilling  to  dispense  with  the  investigation.  But 
wherever  possible  there  was  to  be  cooperation  with  the 
State  banking  authorities  in  order  that  visits  of  examiners 
might  fall  as  nearly  as  possible  on  the  same  days,  and  in 
order  that  there  should  be  no  useless  duplication  of  work. 
In  these  ways  objections  were  somewhat  mitigated. 


STATE  BANK  MEMBERSHIP  63 

It  was  understood  generally  that  the  prime  purpose  of 
the  new  banking  system  was  not  to  secure  profits  for 
stockholders.  Dividend  provisions  were  written  in  the  act 
merely  to  lessen  the  possibility  of  total  loss  of  income  on 
the  capital  subscription  to  the  reserve  bank.  Nevertheless, 
the  average  banker  could  not  refrain  from  taking  into  con- 
sideration this  aspect  of  the  question.  Under  the  terms  of 
the  law  six  per  cent  represented  the  utmost  dividends 
possible  on  the  stock  of  the  reserve  banks.  Additional 
earnings  must  go  to  the  Government  as  a  franchise  tax,  or 
to  surplus.  In  the  early  years,  even  six  per  cent  dividends 
seemed  impossible,  in  view  of  the  small  volume  of  redis- 
counting  and  there  was  the  fear  of  spreading,  by  virtue  of 
excessive  open-market  operations,  the  belief  that  the 
reserve  banks  were  designed  to  compete  with,  and  not  to 
render  service  to,  the  member  institutions.  Many  banks 
felt  their  capital  could  be  made  to  earn  much  more  than 
six  per  cent,  and  were  unwilling  to  place  it,  even  in  small 
quantities,  in  a  field  where  its  profit-getting  opportunities 
were  thus  limited. 

Because  of  these  numerous  doubts,  queries,  and  objec- 
tions, because  the  state  of  the  money  market  was  not  such 
as  to  create  great  dependence  upon  the  Federal  Reserve, 
because  arguments  were  based  so  largely  on  advantage  to 
the  group  and  possibly  not  to  so  great  an  extent  on  the 
self-interest  of  each  bank,  it  does  not  appear  surprising 
that  the  great  number  of  banks,  not  accustomed  to  assum- 
ing positions  of  leadership  in  the  banking  fraternity, 
should  prefer  to  await  future  developments;  that,  in  other 
words,  they  adopted  the  policy  of  watchful  waiting.  It  is 
no  doubt  true  that  the  assumption  of  this  attitude  placed 
the  non-member  institutions  in  a  stronger  strategic  posi- 
tion. It  was  not  to  be  expected  at  the  time  of  the  framing 
of  the  original  act  that  the  lawmakers  would  make  every 


64  FEDERAL  RESERVE  POLICY 

feasible  concession  to  the  State  institutions.  With  more 
experience  in  the  operation  of  the  system,  further  conces- 
sions could  be  made  later.  And  possibly  the  framers  of 
the  act  had  in  mind  the  desirability  of  holding  back  some- 
thing for  future  bargaining  purposes.  At  any  rate,  it  is 
probable  that  the  few  State  institutions  which  joined  prior 
to  the  middle  of  19 17  were  those  which  were  strongly 
impressed  by  this  opportunity  of  stamping  themselves 
with  whatever  guarantees  of  soundness  and  progressive- 
ness  membership  in  the  Federal  Reserve  implied.  Mem- 
bership was  an  advertising  feature  of  no  mean  advantage. 

But  after  the  date  of  our  participation  in  the  World  War, 
the  situation  altered  itself  abruptly.  It  was  understood 
everywhere  that  war  finance  must  increase  greatly  the 
demands  upon  all  classes  of  banks.  Not  merely  was  it 
expected  that  the  general  level  of  commodity  prices  was 
destined  to  advance,  but  the  necessities  of  military  de- 
mands must  throw  greater  strain  upon  our  productive  and 
industrial  organization.  To  wait  longer  in  applying  for 
admission  might  prove  costly.  Entrance  into  the  Federal 
Reserve  could  not  be  accomplished  on  the  moment;  some 
delay  must  be  encountered  while  the  merits  of  the  applica- 
tion for  entrance  were  being  considered.  Previously  the 
Reserve  Board  had  rejected  many  applications  because 
the  past  record  or  present  condition  of  the  bank  was  unsat- 
isfactory.* Nor  was  there  certainty  that  indirect  aid  could 
continue  to  be  had  from  the  Federal  Reserve.  The 
increasing  strain  upon  the  banks  might  place  the  city  cor- 
respondent institutions  in  a  position  where  they  must 
think  more  largely  of  their  own  requirements.  At  the 
same  time  the  occasion  appeared  ripe  for  some  of  our  high 
Government  officials  to  base  their  pleas  for  membership  on 
patriotic  motives.  Early  in  May,  19 17,  a  letter  from  Secre- 

'  Cf.  Report  of  the  Federal  Reserve  Board  for  1915,  p.  12. 


STATE  BANK  MEMBERSHIP  65 

tary  McAdoo  ^  incHcative  of  such  appeals  was  read  before 
the  Executive  Council  of  the  American  Bankers'  Associa- 
tion. The  following  sentences  may  be  quoted  from  this 
letter: 

The  time  may  come  when  the  financial  resources  of  the  coun- 
try will  not  be  commensurate  with  the  national  purpose,  if  the 
nation  remains  half  State  bank  and  half  national  bank  in  its 
organization.  The  State  banks  will  find  greater  security  for 
themselves,  if  disaster  should  threaten,  if  they  are  members  of 
the  Federal  Reserve  system;  and  the  system  will  be  irresistibly 
strong  if  the  State  banks  unite  with  the  national  banks  in  mak- 
ing them  an  extremely  useful  national  instrument. 

I  commend  this  question  to  your  earnest  and  patriotic  con- 
sideration, with  the  sincere  hope  that  love  of  our  common 
country  should  surmount  every  other  consideration  and  bring 
about  this  supremely  desirable  result. 

At  the  same  time  it  began  to  appear  as  if  the  non-mem- 
bers had  gained  all  possible  advantage  from  remaining 
aloof.  In  an  address  delivered  in  Chicago  in  April, ^  Paul 
M.  Warburg  called  attention  to  the  fact  that  the  Board 
had  gone  the  limit  in  its  endeavors  to  provide  favorable 
terms  for  the  entrance  of  State  banks.  He  insisted  that 
since  State  banks  profited  by  the  institution  they  were 
under  obligation  to  support  it. 

In  the  matter  of  friendly  legislation  much  progress  had 
also  been  recently  accomplished.  In  the  previous  year  or 
so  some  of  the  few  States  which  had  been  tardy  in  enacting 
the  necessary  enabling  legislation  wrote  statutes  empower- 
ing State  institutions  to  become  stockholders  in  the  Fed- 
eral Reserve  Banks.  These  States  were  Delaware,  Idaho, 
Kansas,  Montana,  North  Dakota,  South  Dakota,  and 
Washington.     Furthermore,   Federal   legislation  of  very 

'  This  letter  is  printed  in  part  in  the  Commercial  ami  Financial  Chronicle  for 
May  12,  1917,  pp.  18.U-35. 

'  Cf.  Commercial  ani  Financial  Chronicle,  April  14,  1917,  pp.  1450-51. 


66  FEDERAL  RESERVE  POLICY 

great  importance  was  enacted  in  the  amendment  to  the 
Federal  Reserve  Act  on  June  21,  19 17.  The  most  impor- 
tant concessions  therein  granted  were  the  following :  ^ 

1.  Any  State  bank  or  trust  company  desiring  to  withdraw 
from  membership  in  a  Federal  Reserve  bank  may  do  so,  after 
six  months'  written  notice  shall  have  been  filed  with  the  Federal 
Reserve  Board,  upon  the  surrender  and  cancellation  of  all  its 
holdings  of  capital  stock  in  the  Federal  Reserve  bank. 

2.  Subject  to  the  provisions  of  this  act  and  to  the  regulations 
of  the  board  made  pursuant  thereto,  any  bank  becoming  a 
member  of  the  Federal  System  shall  retain  its  full  charter  and 
statutory  rights  as  a  State  bank  or  trust  company,  and  may 
continue  to  exercise  all  corporate  powers  granted  it  by  the  State 
in  which  it  was  created.  .  .  . 

The  first  of  these  concessions  placed  in  definite  statu- 
tory form  what  previously  had  been  merely  a  ruling  of  the 
Board.  In  case  \vithdrawal  should  be  desired,  voluntary 
liquidation  would  no  longer  be  necessary.  By  the  second 
concession  guarantee  was  given  that  entrance  into  the 
system  need  not  result  in  the  loss  of  rights  and  powers 
possessed  at  the  time  of  entrance,  provided  these  were  not 
in  conflict  with  the  terms  of  the  act  or  the  regulations  of 
the  Board.  And  aside  from  the  clauses  relating  directly 
to  the  terms  of  membership  in  the  system,  a  further  wel- 
come feature  of  this  amendment  was  the  lowering  in  the 
legal  reserve  minima.  After  these  statutory  concessions 
had  been  granted,  the  President  felt  justified  shortly 
afterward  in  asserting ""  that  "membership  in  the  Federal 
Reserve  system  is  a  distinct  and  significant  evidence  of 
patriotism." 

The  efTect  of  these  appeals,  of  these  statutory  changes, 
and  of  the  altered  financial  condition  of  the  country  was 

'  See  Section  9  of  the  amended  act. 

'  Statement  of  President  Wilson  made  public  through  the  Federal  Reserve 
Board.  See  Btdlelin,  November,  1917,  pp.  827-28. 


STATE  BANK  MEMBERSHIP  67 

soon  made  manifest  by  an  increased  membership.  It  has 
been  remarked  that  on  June  21,  1917,  the  number  of  mem- 
ber State  institutions  was  53  with  total  resources  of  ^825,- 
000,000.  By  January  31,  1918,  296  State  institutions  with 
total  resources  of  more  than  five  billions  of  dollars  had 
become  members.^  By  September  i,  1921,  more  than  1600 
State  institutions  were  members  with  total  resources  of 
nearly  ten  billions  of  dollars.  ^ 

It  seems  undeniable,  therefore,  that  remarkable  suc- 
cess was  achieved  finally  in  enlisting  members  from  State 
banks  and  trust  companies.  It  is  true  that  the  total  num- 
ber of  non-member  institutions,  with  resources,  enormous 
in  the  aggregate,  far  outnumber  those  which  have  joined. 
Many  of  these,  however,  would  not  be  eligible  for  member- 
ship, and  many  would  not  add  to  the  strength  of  the  sys- 
tem if  they  were  admitted.  It  should  not  be  forgotten  that 
a  number  of  applications  have  been  refused,  and  the  effect 
of  these  refusals  has  undoubtedly  influenced  many  other 
banks,  whose  financial  strength  was  somewhat  similar, 
not  to  make  applications.  It  is  true  that  many  strong  .and 
powerful  institutions  remain  outside  the  fold,  but  suffi- 
cient success  has  been  achieved  to  render  improbable  the 
danger  of  warfare  between  members  and  non-members. 
When  one  recalls  that  in  one  matter  of  the  utmost  impor- 
tance to  the  State  banks  —  the  clearance  and  collection  of 
checks  —  no  concession  of  principle  was  made,  it  appears 
that  the  Board  should  be  lauded  for  its  general  good  tact 
and  administrative  efficiency.  Few  proposals  of  the  sort 
once  most  earnestly  advocated  are  now  to  be  heard,  pro- 
posals which  if  worked  out  might  have  split  the  country 
into  two  rival  camps,  proposals  that  non-members  estab- 
lish a  country-wide  clearing  system  of  their  own.    Of 

'  See  Bulletin,  February  i,  1918,  p.  92. 

'  See  ibid.,  issue  of  September,  192 1,  p.  1078. 


68  FEDERAL  RESERVE  POLICY 

course  It  may  be  true  that  the  accretion  in  membership 
was  merely  the  by-product  of  a  too  liberal  discount  policy. 
But  this  is  another  problem  and  calls  for  special  discussion 
in  a  later  chapter. 

One  interesting  aspect  of  the  State  bank  membership 
problem  remains  for  discussion.  What  has  been  the  effect 
of  the  legislative  efforts  to  attract  State  bank  members 
upon  laws  governing  the  operations  of  national  banks? 
With  no  concession  to  national  banks  their  position  as 
competitors  of  State  banks  would  become  less  secure. 
There  was  danger  of  stunting  the  growth  of  the  national 
banks.  To  check  this  danger,  legislation  was  enacted 
broadening  under  certain  circumstances  the  powers  of 
national  banks.  Legislation  of  this  sort  was  contained  in 
the  act  of  September  26,  1918.  The  Import  of  this  can  be 
understood  best  by  quoting  an  Opinion  of  Counsel  of  the 
Federal  Reserve  Board  as  to  its  application :  * 

Under  the  provisions  of  section  1 1  (k)  as  amended  by  the  act 
of  September  26,  191 8,  the  Federal  Reserve  Board  may  properly 
permit  any  national  bank  to  exercise  any  of  the  fiduciary 
powers  authorized  by  that  section,  unless  there  is  some  express 
provision  of  the  laws  of  the  State  in  which  such  bank  is  located 
which  either  directly  or  by  necessary  implication  prohibits 
national  banks  from  exercising  such  powers,  and  even  if  there 
is  such  an  express  statute,  the  Board  may  issue  its  permit  if  any 
State  bank,  trust  company  or  other  competing  corporation  in 
that  State  is  permitted  to  exercise  the  powers  applied  for  by 
the  national  bank. 

An  indirect  result  of  the  problem  of  State  bank  member- 
ship has  thus  been  to  encourage  the  tendency  toward 
"department  store"  banking.  It  is  probable  that  there 
will  be  a  further  development  of  this  tendency  in  the 
future.  Many  national  bank  directorates  feel  that  the  law 
is  not  quite  fair  to  their  institutions.    In  many  respects, 

'  See  Bulletin,  April,  1919,  p.  363. 


STATE  BANK  MEMBERSHIP  69 

such  as  that  of  prestige,  membership  in  the  Federal 
Reserve  serves  all  the  purposes  previously  requiring 
national  incorporation.  These  directorates  are  considering 
reincorporation  as  State  banks  in  order  to  gain  the  advan- 
tage of  more  liberal  legislation.  Particularly  in  the  matter 
of  the  establishment  of  branches  there  is  a  general  demand 
that  national  banking  law  be  made  more  affirmatively 
liberal. 


CHAPTER  IV 
ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS 

The  purpose  of  this  chapter  is  to  explain  the  machinery 
and  conditions  under  which  the  funds  of  reserve  banks 
through  the  medium  of  rediscounts  may  be  made  avail- 
able for  member  institutions.  The  reader  will  bear  in  mind 
that  rediscounting  is  not  the  sole  means  by  which  reserve 
banks  may  employ  their  resources.  Through  an  amend- 
ment to  the  original  act,  later  to  be  discussed,  reserve 
banks  secured  authority  for  rendering  direct  aid  by  dis- 
counting the  notes  of  the  member  banks  themselves. 
Indirectly  also,  through  their  open-market  operations, 
further  aid  may  be  extended.  Our  present  purpose,  how- 
ever, is  to  discuss  one  type  only  of  reserve  bank  operations, 
rediscounts,  or  the  discount  of  paper  which  originated  at  a 
prior  date,  the  parties  concerned  being  in  most  cases  the 
member  bank  and  one  of  its  clients. 

It  seems  logical  to  give  rediscounts  rather  than  the 
other  operations  the  place  of  priority  in  our  discussion. 
Not  for  a  considerable  period  after  the  date  of  inaugura- 
tion were  reserve  banks  given  permission  to  make  direct 
advances  to  member  institutions.  While  reserve  banks  did 
possess  from  the  very  beginning  certain  powers  of  direct 
dealings  in  the  open  market,  such  functions  were  not  the 
most  emphasized.  In  the  exercise  of  their  open -market 
powers  the  reserve  banks  often  must  assume  the  position 
of  competitors  of  member  banks ;  their  policies  may  have 
been  adopted  for  the  purpose  of  controlling  the  money 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS  71 

market,  possibly  with  the  result  of  interfering  with  the 
profit-making  operations  of  the  member  institutions.  If 
conducted,  not  for  the  purpose  of  control,  but  merely 
for  the  sake  of  securing  more  complete  employment  for 
their  resources,  these  direct  dealings  may  lessen  the  de- 
pendence of  the  public  upon  the  member  institutions. 
Only  in  rediscount  operations  is  the  character  of  the 
reserve  system  displayed  consistently  as  of  a  cooperative 
nature,  only  then  does  the  reserve  system  appear  as  an 
institution  designed  to  render  service  to  its  member  banks. 
Since  in  the  early  years  of  operation  every  device  of  sound 
banking  must  be  employed  in  order  to  secure  the  alle- 
giance of  the  individual  banks  of  the  country;  since  with- 
out their  generous  support  the  Federal  Reserve  must  have 
failed  to  secure  the  resources  and  influence  necessary  to 
enable  it  to  function  as  intended,  the  helpful  possibilities 
of  the  system  have  been  the  most  advertised.  To-day  a 
layman,  asked  to  define  the  functions  of  the  reserve  banks, 
would  undoubtedly  reply  —  they  are  institutions  de- 
signed to  aid  member  banks  by  rediscounting  commercial 
paper. 

Statutory  provisions  regarding  rediscounts  are  con- 
tained in  section  13  of  the  act.  The  general  purport  of  the 
terms  of  this  section  was  to  encourage  sound  methods  of 
commercial  banking  and  to  maintain  liquid  the  assets  of 
the  reserve  banks.  Accordingly  reserve  banks  may  redis- 
count only  paper  which  arises  in  the  short-time,  self- 
liquidating  operations  of  trade,  industry,  and  agriculture. 
More  specifically  the  leading  provisions  of  this  section 
were: 

(i)  Reserve  banks  are  permitted  to  rediscount  paper  en- 
dorsed by  member  banks  which  arises  out  of  and  the  proceeds  of 
which  arc  employed  for  agricultural,  industrial  or  commercial 
purposes. 


72  FEDERAL  RESERVE  POLICY 

(2)  Paper  covering  merely  investments  or  drawn  for  the 
purpose  of  carrying  or  trading  in  stocks,  bonds,  or  other  invest- 
ment securities  is  rendered  inehgible. 

(3)  The  definition  of  inehgible  paper,  however,  does  not  cover 
"that  issued  or  drawn  for  the  purpose  of  carrying  or  trading  in 
.  .  .  bonds  and  notes  of  the  Government  of  the  United  States." 

(4)  Paper  drawn  for  agricultural  purposes  or  based  on  live 
stock  may  have  a  maturity  at  the  time  of  discount  by  the  re- 
serve bank  of  six  months.  Other  eligible  paper  must  have  a 
maturity  not  in  excess  of  three  months. 

So  much  emphasis  has  been  placed  upon  the  desira- 
bility that  rediscounted  paper  should  comply  with  these 
requirements  that  it  is  commonly  assumed  that  it  would 
not  have  been  in  the  interests  of  sound  or  conservative 
reserve  banking  to  have  included  other  varieties  of  eligible 
paper.  Of  late,  however,  some  voices  have  been  heard 
denying  the  assumption  that  eligible  paper  should  be 
defined  thus  narrowly.^  In  order  that  later  we  may  form  a 
judgment  as  to  the  desirability  of  the  qualifications  con- 
tained in  the  act,  it  may  be  well  to  recall  some  of  the  lead- 
ing objections  offered  to  the  rediscount  of  speculative  or 
investment  paper. 

First  of  all,  it  was  believed  that  these  restrictions  were 
necessary  in  order  to  keep  liquid  the  funds  of  the  reserve 
banks.  In  the  course  of  time  it  was  expected  that  the  loan- 
ing power  of  the  reserve  institutions  w^ould  become  the 
ultimate  reserve  of  the  country.  Far  more  important  then 
would  it  be  that  the  reserve  funds  should  be  easily  avail- 
able than  those  of  any  private  bank.  Member  banks  could 
rely  if  necessary  upon  the  reserv^e  institutions  for  aid,  but 
no  easily  accessible  source  of  relief  would  be  open  to  the 
reserve  institutions.  Their  reserves  would  constitute  the 
last  line  of  defense  in  a  period  of  threatened  liquidation. 

'  Cf.  for  instance,  Anna  Youngman,  "  The  Efficacy  of  Changes  in  the  Discount 
Rates  of  the  Federal  Reserve  Banks,"  American  Economic  Review,  September, 
192 1,  pp.  463-86. 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS  73 

In  the  second  place,  there  was  a  general  desire  to  seize 
every  opportunity  offered  by  the  establishment  of  the  new- 
system  to  encourage  sound  banking  methods  on  the  part 
of  the  member  institutions.  Not  merely  does  the  strength 
of  the  reserve  system-depend  largely  upon  the  strength  of 
the  member  banks,  but  the  advantages  to  the  public 
arising  from  the  formation  of  the  reserve  system  might  be 
lost  if  member  banks  should  be  encouraged  to  invest  too 
large  a  proportion  of  their  resources  in  slow  assets.  From 
the  standpoint,  then,  of  the  condition  of  member  banks, 
every  effort  should  be  exerted  to  maintain  the  liquid  char- 
acter of  the  paper  in  their  portfolios. 

Certain  objections,  somewhat  of  a  political  character, 
also  lay  in  the  way  of  the  admission  of  paper  arising  out  of 
investment  or  speculative  operations.  As  remarked  in  a 
previous  chapter  the  support  of  the  interior  banks  and  of 
the  business  public  coukl  not  easily  have  been  secured  for 
a  plan  whereby  the  reservoir  of  funds  for  investment  and 
speculative  activities  could  be  increased  by  the  use  of  the 
contributions  of  all  member  banks,  large  as  well  as  small, 
metropolitan  as  well  as  rural.  To  repeat  a  former  observa- 
tion, the  Federal  Reserve  plan  was  directed  largely  against 
Wall  Street;  its  support  among  a  large  class  of  bankers 
depended,  not  so  much  on  any  sound  conviction  as  to  the 
merits  of  the  numerous  technical  objections  to  the  old 
system,  as  to  discontent  arising  out  of  the  difficulties 
experienced  by  banks  of  the  interior  in  securing  the  return 
of  funds  invested  in  1907  in  the  securities  market  of  New 
York  City.  Allegiance  to  the  reform  system  could  not  be 
secured  easily  without  the  guarantee  that  the  surplus  re- 
serves of  commercial  banks  should  be  kept  available  for  the 
needs  of  commerce  and  agriculture  instead  of  swelling  in 
the  slack  seasons  and  years  the  reservoir  of  stock  market 
funds.  Rediscounting  of  speculative  paper  must  be  refused. 


74  FEDERAL  RESERVE  POLICY 

What,  moreover,  about  the  inflationary  possibilities  of 
the  new  system?  Everywhere  was  it  understood  how,  by 
the  concentration  of  reserves  and  the  resulting  pyramiding 
of  credits,  the  reserve  system  would  make  possible  vastly 
enlarged  amounts  of  bank  advances.  Would  expanding 
credit  grants,  thus  rendered  possible,  exert  a  lifting  influ- 
ence upon  the  general  price  level  and  exaggerate  the  diffi- 
culties already  generally  attributed  to  a  faulty  standard 
of  deferred  payments?  In  answer  to  such  queries  there  was 
a  general  denial  by  the  members  of  a  certain  school  of 
currency  students  of  any  direct  connection  between 
expanding  grants  of  commercial  credit  and  the  general 
level  of  commodity  prices.  This  school  argued  that  only 
when  bank  funds  were  borrowed  for  investment  or  specu- 
lative purposes  the  cause  of  a  resulting  higher  level  of, 
prices  could  be  attributed  to  any  enlargement  of  bank 
advances.  The  real. danger  lay  in  pouring  too  large  a 
proportion  of  the  country's  banking  resources  into  the 
investment  reservoir.  Possibly  the  clearest  brief  statement 
of  this  point  of  view  is  that  of  Professor  C.  C.  Arbuthnot 
in  the  American  Economic  Review  for  December,  1920.' 
His  statement  was  made  for  another  application,  but  well 
summarizes  certain  views  earlier  expressed  regarding  Fed- 
eral Reserve  policy.  To  quote  from  his  argument : 

In  the  ordinary  processes  of  business  the  credit  of  commercial 
banks  is  used  to  assist  in  the  purchase  and  sale  of  marketable 
goods.  It  takes  the  form  of  short-time  notes  which  are  to  be 
paid  from  the  receipts  from  the  sold  goods.  The  extension  of 
credit  to  permit  buying  is  accompanied  almost  simultaneously 
by  an  offer  in  the  market  of  the  salable  commodities.  The  effec- 
tive demand  for  goods  thus  made  possible  is  accompanied  by  the 
supply  of  goods.  The  equilibrium  between  supply  and  demand 
is  not  seriously  disturbed  and  the  extension  of  credit  has  no 

■  Cf.  pp.  779-80.  The  subject  of  Mr.  Arbuthnot's  article  was  "A  Stabilized 
Dollar." 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS  75 

lifting  influence  on  the  general  level  of  prices.  As  long  as  com- 
mercial bank  credit  serves  this  purpose  there  is  no  inflation. 

As  will  be  indicated  later,  this  view  does  not  harmonize 
with  that  of  the  writer.  Nevertheless,  with  various  modi- 
fications and  refinements  it  represented  the  view  of  many. 
Since  it  was  inevitable  that  the  reduction  of  reserve  min- 
ima under  the  Federal  Reserve  would  expand  greatly  the 
potential  volume  of  bank  credit,  acceptance  of  this  view 
necessitated  a  careful  attempt  to  restrict  the  use  of  reserve 
resources  for  investment  purposes. 

The  above  fears  of  price  inflation  had  to  do  with  the 
probable  results  of  too  great  advances  to  the  investment 
market.  But  when  bank  funds  are  employed  for  another 
purpose,  the  withholding  of  goods  from  early  consumption 
—  for  commodity  speculation,  in  other  words  —  there 
was  general  agreement  as  to  the  lifting  influence  upon  the 
price  level  of  the  bank  funds  thus  advanced.  Clearly,  it  was 
unanimously  agreed,  reserve  funds  must  not  be  made 
available  to  the  commodity  speculator. 

Many  controversial  points  were  involved  in  the  argu- 
ments stated  above.  It  is  the  writer's  belief  that  to-day 
there  is  an  even  greater  tendency  to  dispute  the  validity 
of  some  of  these  tenets.  But  their  truth  accepted,  the 
practical  problem  became  that  of  framing  measures  which 
would  effectively  discourage  the  use  of  reserve  funds  for 
speculation  or  investment.  In  other  words,  it  was  a  matter 
of  devising  tests  or  standards  according  to  which  the  com- 
mercial character  of  the  paper  offered  for  rediscounts  could 
best  be  determined.  Several  possibilities  received  some 
attention  in  this  connection.  First,  admissible  paper  must 
be  of  the  double-name  rather  than  of  the  single-name  type. 
Second,  statements  of  conditions  of  the  maker's  assets 
could  be  required.  Finally,  in  a  more  informal  way,  reli- 
ance could  be  placed  upon  the  knowledge  of  the  applying 


76  FEDERAL  RESERVE  POLICY 

banker  as  to  the  purpose  for  which  the  funds  originally 
obtained  were  employed.  Let  us  first  turn  our  attention  to 
the  matter  of  double-name  paper. 

The  case  for  admitting  double-name  paper  only  was 
based  upon  a  number  of  arguments.  In  the  first  place,  its 
form  was  such  as  to  offer  greater  indication  of  the  com- 
mercial nature  of  the  underlying  transaction.  Every 
operation  of  trade  involves  at  least  two  parties.  If  admis- 
sion of  the  indebtedness  is  evidenced  by  a  draft,  the  seller 
of  the  goods  becomes  the  drawer,  the  purchaser  the 
drawee.  If  the  promissory  note  is  employed,  the  payee  or 
his  agent  is  the  seller,  the  maker  the  purchaser.  Since 
these  two  parties  are  always  involved  in  a  trade  transac- 
tion, why  not  require  their  names  and  their  combined 
security  in  the  paper  which  arises  when  resort  is  had  to 
bank  funds.  In  case  two-name  paper  cannot  be  supplied, 
there  is  greater  likelihood  that  in  the  underlying  transac- 
tion the  purchaser  is  not  to  liquidate  his  account  out  of  the 
proceeds  of  the  sale  of  the  goods,  and  the  paper  is  not 
liquid.  If  two-name  paper  can  be  supplied,  there  is  one  in- 
dication, not  conclusive  to  be  sure,  but  informative,  never- 
theless, of  the  liquidating  character  of  the  transaction. 

In  the  second  place,  it  was  asserted  that  single  name  paper 
indicates  more  often  lax  customs  of  trade  credit.  The  buyer 
is  more  tempted  to  buy  unwisely,  the  seller  to  overextend 
credit  or  accept  bad  debt  accounts,  when  the  buyer  is  not 
compelled  to  acknowledge  immediately  his  indebtedness. 
Single-name  paper  often  originates  because  of  the  desire  of 
the  buyer  to  postpone  the  date  of  formal  acknowledgment 
of  his  obligation.  At  the  time  of  shipment  and  for  a  certain 
period  thereafter  he  insists  upon  being  carried  on  the  open 
book  account.  Inevitably  this  delay  must  increase  the 
likelihood  of  bad  debts,  slow  payments,  expensive  collec- 
tions—  in  short,  irregularities  in  our  trade  credit  methods. 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS    77 

As  a  special  irregularity  thus  created,  it  was  further- 
more insisted  that  single-name  paper  necessarily  gives  rise 
to  many  duplications.  These  duplications  could  usually  be 
attributed  to  the  ability  of  the  buyer  to  avoid  the  im- 
mediate creation  of  paper  which  when  discounted  would 
render  him  subject  to  a  call  from  the  bank.  In  the  absence 
of  careful  analysis  of  financial  statements,  single-name 
methods  permit  the  same  person  to  borrow  from  a  bank  and 
from  a  commercial  paper  house.  Some  firms  established 
connections  with  several  note  brokerage  concerns  and  sell 
through  them  all.  The  practice  of  registering  with  a  trust 
company  paper  thus  sold  had  its  origin  in  the  endeavor  of 
some  firms  to  prove  they  were  not  duplicating  security  in 
this  manner.  Some  firms  borrow  largely  on  their  showing 
of  book  account  and  later  assign  these  to  selling  agents.* 
If  one  party  could  not  obtain  bank  funds  without  joining 
simultaneously  the  other  party  to  the  trade  transaction, 
such  duplications  would  become  more  difficult. 

Finally  it  was  contended  that  the  admission  of  single- 
name  paper  must  encourage  the  acquirement  of  precisely 
the  sort  of  paper  for  which  there  was  little  foreign  demand. 
In  Europe  a  broad  market  existed  only  for  prime  paper  of 
the  double-name  type.  One  of  the  underlying  purposes  of 
the  Federal  Reserve  Act  was  to  create  a  constant  open 
market  for  prime  paper,  both  in  the  home  and  foreign 
markets.  A  broader  home  market  alone  would  not  solve 
difficulties  due  primarily  to  such  international  facts  as 
excessive  gold  exports  arising  from  an  unfavorable  balance 
of  trade.  In  defining  eligible  paper  a  wonderful  opportu- 
nity existed  to  correct  the  situation  wherein  commercial 
banks  were  induced  to  invest  surplus  funds  in  stock  ex- 
change activities.   But  to  secure  the  utmost  of  advantage 

»  Cf.  E.  E.  Agger,  "The  Commercial  Paper  Debate,"  Journal  of  Political 
Economy,  July,  19 14,  pp.  670-71. 


78  FEDERAL  RESERVE  POLICY 

the  requirements  of  foreign  as  well  as  of  domestic  demand 
must  be  taken  into  account.  Single-name  paper  possessed 
inferior  standing  abroad. 

Many  objections  of  a  practical  character,  however,  must 
be  met  by  those  insisting  upon  the  exclusive  acceptance  of 
double-name  paper.  One  of  the  most  obvious,  as  well  as 
most  compelling  of  these,  was  the  very  great  lack  of  good 
double-name  paper  in  the  American  market.  It  has  been 
asserted  that  at  the  time  of  the  framing  of  the  act,  trade 
paper  arose  in  less  than  three  per  cent  of  the  total  credit 
transactions  of  the  country.*  Of  this  three  per  cent  a  very 
large  part  consisted  of  paper  arising  in  settlement  of  post- 
due  accounts.  With  double-name  paper  alone  admissible, 
it  was  clear  that  the  reserve  system  could  render  little  real 
aid  to  the  member  banks.  If  it  was  not  to  degenerate  into 
an  impotent  and  unused  mechanism,  it  must  take  account 
of  the  actualities  of  the  situation  and  not  merely  hypothet- 
ical or  idealistic  considerations.  Of  course  the  reserve  ad- 
ministration would  be  expected  to  plan  consistently  for  the 
development  of  more  sound  methods  of  trade  and  bank  cre- 
dit. Some  time  must  elapse,  however,  before  any  consider- 
able alteration  of  existing  methods  could  be  accomplished. 

The  above  argument  could  be  addressed  to  practically 
all  the  commercial  banks  of  the  country.  But  an  espe- 
cially appealing  objection  could  be  addressed  to  the  great 
number  of  small  bankers  on  the  ground  that  double-name 
paper  alone  must  mean  discrimination  in  favor  of  the 
large  city  institutions.  In  the  main,  it  was  argued,  the 
small  bank  is  the  bank  of  the  retailer;  whereas  the  whole- 
saler, jobber,  and  manufacturer  must  depend  on  the  urban 
banking  house.  Because  of  the  small  amount  and  informal 
character  of  his  average  credit  transaction,  the  retailer 

»  Cf.  E.  E.  Agger,  "The  Commercial  Paper  Debate,"  Journal  of  Political 
Economy,  July,  1914,  p.  663. 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS  79 

cannot  offer  his  banker  any  large  amount  of  double-name 
paper.  Except  in  cases  of  post-due  accounts  and  slow  pay- 
ments, custom  and  competition  do  not  permit  him  to 
demand  notes  or  to  require  the  acceptance  of  drafts  from  his 
customers.  In  the  wholesalers'  transactions,  however, 
wherein  considerations  of  custom  must  be  somewhat  less 
important  relatively  than  those  of  business  efficiency,  a 
future  field  for  the  creation  of  double-name  paper  was  dis- 
cernible. But  what  would  be  the  justice  and  the  political 
expediency  of  a  programme  which  would  admit  as  eligible 
only  paper  contained  in  large  volume  in  the  portfolios  of 
the  city  institutions?  Acceptance  of  this  proposal  would 
compel  country  banks  to  purchase  paper  in  the  open  mar- 
ket in  case  they  desired  to  draw  upon  the  reserve.  But  the 
advantage  of  such  a  course  of  action  would  be  dubious.  It 
is  true  that  rediscounting  would  increase  the  bank's 
reserve.  But  payment  for  the  paper  purchased  would  tend 
to  tear  it  down  in  corresponding  degree. 

Neither,  it  was  insisted,  was  there  any  guarantee  that 
funds  obtained  by  the  discount  of  two-name  paper  would 
not  be  employed  for  investment  or  speculative  purposes. 
The  funds  obtained  by  the  discount  of  admissible  paper 
might  be  put  to  any  use  desired.  In  the  words  of  IMoulton, 
written  for  another  purpose:  * 

It  will  be  recalled,  from  our  previous  analysis  of  the  relation 
of  the  commercial  banking  system  to  the  financing  of  stock 
exchange  speculation,  to  the  outright  purchase  of  securities, 
to  the  making  of  collateral  loans  for  fixed  capital  purposes  and 
to  the  activities  of  investment  bankers  engaged  in  the  marketing 
of  securities,  that  the  funds  of  the  commercial  banking  system 
constitute  the  support  for  the  entire  financial  fabric,  invest- 
ment and  speculative,  as  well  as  commercial. 

Of  course  it  might  be  argued  that  to  make  this  class 
of  paper  alone  admissible  would  increase  its  desirability  to 

'  Financial  Organization  of  Society,  p.  633. 


8o  FEDERAL  RESERVE  POLICY 

the  member  banks.  But  ought  not  the  general  liquidity 
of  the  borrower's  assets  and  not  the  form  of  the  paper  to 
determine  the  right  to  request  Federal  Reserve  aid. 
Because  of  the  nature  of  their  operations  some  borrowers 
cannot  gain  possession  of  double-name  paper.  If  their 
assets  in  general  are  sufhciently  liquid,  should  not  their 
paper  be  rediscountable?  As  Sprague  puts  it:  ^ 

The  fundamental  point  at  issue  is  whether  an  analysis  of  the 
entire  financial  position  of  the  borrower  or  a  series  of  particular 
transactions  affords  the  lender  better  safeguards  against  loss. 

It  could  be  contended,  furthermore,  that  discrimination 
in  favor  of  double-name  paper  might  tend  to  increase  the 
volume  of  unsound  paper.  Eligibility  for  rediscounts  is 
purely  a  matter  of  arbitrary  definition.  Nevertheless,  it 
might  become  one  of  the  principal  bases  ofTered  in  the  open 
market  for  testing  its  worth.  Single-name  paper,  because 
of  the  possible  misuse  of  the  funds,  because  of  the  fact  that 
only  one  party  is  responsible,  puts  the  purchaser  on  guard. 
He  is  not  nearly  so  likely  to  avoid  the  usual  safeguards  of 
examination  and  inquiry  when  his  paper  is  not  of  the  sort 
encouraged  by  the  definition  of  eligibility.  In  the  discount 
of  two-name  paper,  no  margin  of  collateral  over  credit 
obtained  would  usually  be  required. 

In  a  pragmatic  sort  of  way,  some  measure  of  truth  may 
be  contained  in  this  objection.  Too  much  attention  to 
form  might  lessen  dependence  upon  careful  analysis  of  the 
borrower's  condition.  If  such  abuses  should  appear,  how- 
ever, the  method  of  correction  would  be  easily  available. 
Merely  let  there  be  redoubled  devotion  to  the  usual  safe- 
guards.   In  Warburg's  words:" 

It  has  never  been  contended  by  the  champions  of  the  trade 

'  See  O.  M.  W.  Sprague,  "The  Federal  Reserve  Banking  System  in  Opera- 
tion," Quarterly  Journal  of  Economics,  August,  1916,  p.  649. 
'  See  Bulletin,  Jul>  i,  1918,  pp.  604-06. 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS  8i 

acceptance  that  these  acceptances  should  be  bought  by  any  one 
who  has  not  famiharized  himself  thoroughly  with  the  financial 
condition  of  the  maker  of  the  paper;  he  should  take  this  pre- 
caution just  as  if  he  were  buying  a  single-name  note,  and  as 
long  as  he  does  that  there  is  no  reason  whatever  why  he  should 
not  be  capable  of  judging  solvency  and  standing  from  the  state- 
ment of  a  borrower  who  sells  the  trade  acceptance  he  receives 
just  as  he  can  from  the  statement  of  a  firm  which  borrows  only 
on  its  own  note. 

Admonitions  of  this  sort,  however,  were  frequently 
sufficient  to  lessen  the  ardor  of  many  advocates  of  double- 
name  paper.  It  was  expected  by  many  that  a  change  in 
the  form  of  trade  paper  must  lessen  the  need  of  tedious  and 
careful  examination.  When  it  became  apparent  that  a 
mere  change  in  form  could  not  accomplish  everything, 
there  was  a  marked  reaction  to  the  view  that  the  main  pre- 
requisite of  eligible  paper  must  be  the  general  character 
of  the  borrower's  assets. 

As  a  final  objection  to  the  sole  admission  of  two-name 
paper,  it  was  argued  that  its  use  would  transfer  part  of  the 
work  of  rating  the  credit  of  the  buyer  from  the  bank  to  the 
selling  merchant.  Under  the  single-name  paper  method  the 
bank  must  satisfy  itself  regarding  the  standing  of  the  bor- 
rower (the  buyer) .  Under  the  double-name  plan  the  borrow- 
er's ability  to  obtain  credit  would  depend  in  the  first  in- 
stance upon  the  seller's  rating  of  the  buyer.  Because  of  the 
addition  of  the  seller's  contingent  liability  in  the  bank  bor- 
rowing, dubious  trade  paper  might  become  the  basis  for 
bank  credit.  In  other  words,  it  was  insisted  that  the  buyer's 
bank  ordinarily  possesses  superior  means  of  testing  the 
buyer's  solvency  to  that  of  the  seller  of  the  merchandise. 

Undoubtedly  there  was  a  good  deal  of  force  in  this  argu- 
ment. But  it  merely  emphasizes  the  necessity  of  careful 
analysis  of  the  standing  of  the  buyer  as  well  as  of  the  seller. 
It  also  brought  into  clearer  relief  the  viewpoint  that  the 


82  P^EDERAL  RESERVE  POLICY 

principal  consideration  was  the  credit  rating  of  the  parties 
and  not  primarily  the  form  of  the  paper.  There  did  not 
appear  to  be  sufficient  warrant  for  the  absolute  rejection  of 
single-name  paper.  Accordingly,  the  principal  statutory 
provision  relating  to  eligible  paper  makes  the  test,  not  the 
form  of  the  paper,  but  the  purpose  for  which  the  proceeds 
have  been  or  are  to  be  employed. 

But  were  there  not  certain  other  feasible  means  of 
increasing  the  use  of  trade  paper?  Could  not  less  strict 
qualifications  and  less  complete  information  as  to  the 
nature  of  the  transaction  be  required  in  the  case  of  double- 
name  paper?  In  view  of  the  difficulties  just  disclosed 
regarding  the  dangers  of  insufficient  examination,  such  a 
course  would  appear  extra-hazardous.  But  if  not  this, 
could  not  the  total  volume  of  rediscounts  obtainable  by 
one  member  bank  be  made  the  greater  in  cases  where  the 
applications  were  in  large  part  double-name  paper?  Objec- 
tion to  such  a  policy  was  the  probability  that  some  sec- 
tions of  the  country  would  be  unfairly  treated.  Many 
communities,  particularly  the  rural  and  the  village,  could 
not  be  expected  to  originate  any  large  volume  of  two-name 
paper.  There  thus  remained  the  possibility  of  granting  a 
preferential  rate  of  discount  to  applications  covering  the 
new  kind  of  paper.  To  anticipate  future  discussion,  the 
policy  of  preferential  rate  treatment  has  been  adopted 
during  a  large  part  of  the  period  of  reserve  operation. 

The  Federal  Reserve  Board's  first  regulations  regarding 
discountable  paper  may  now  be  briefly  summarized.  In  an 
early  communication.  Circular  Number  13,^  reserve  banks 
were  requested  to  confine  their  operations  to  short-time, 
self-liquidating  paper  arising  from  commercial,  agricul- 
tural, or  industrial  needs,  and  to  exercise  particular  care  to 

'  This  circular  is  accessible  in  convenient  form  in  the  Commercial  ajid  FinaU' 
cial  Chronicle,  November  14,  1914,  pp.  1416-17. 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS  83 

avoid  furnishing  capital  merely  for  investment  or  specula- 
tive purposes.  Funds  desired  for  fixed  improvements 
would  fall  in  the  ineligible  class.  The  maturities  of  the 
paper  rediscounted  should  be  well  distributed,  and  the 
paper  should  be  non-renewable.  To  quote  from  the  cir- 
cular regarding  the  distribution  of  the  maturities : 

It  is  a  general  rule  (in  Europe)  not  to  purchase  paper  having 
more  than  90  days  to  run.  The  maturities  of  these  notes  and 
bills  are  so  well  distributed  as  to  enable  these  banks  within  a 
short  time  to  strengthen  their  hold  on  the  general  money  mar- 
ket by  collecting  at  maturity  or  by  reinvesting  at  a  higher  rate 
a  very  substantial  proportion  of  their  assets.  Acting  on  this 
principle,  the  Federal  Reserve  banks  should  be  in  position  to 
liquidate,  whenever  such  a  course  is  necessary,  substantially 
one  third  of  all  their  investments  within  a  period  of  30  days. 
Departure  from  this  principle  will  endanger  the  safety  of  the 
system.  It  is  observance  of  this  principle  that  affords  justifica- 
tion for  permitting  member  banks  to  count  balances  with  Fed- 
eral Reserve  banks  as  the  equivalent  of  cash  reserves. 

As  a  means  of  determining  the  self-liquidating  character 
of  the  paper,  the  method  of  procedure  is  next  outlined. 
The  Board  was  evidently  impressed  by  the  desirability  of 
considering  more  than  the  nature  of  the  specific  underlying 
transaction,  for  the  procedure  outlined  to  become  effective 
after  January  15,  1915,  practically  called  for  a  statement  of 
condition  of  the  borrowing  firm.  Since,  however,  the 
Board  did  not  wish  to  lay  down  rules  which  might  involve 
needless  delay  or  difficulty  in  rediscounting,  it  was  not 
insisted  that  a  statement  of  condition  be  attached  to  each 
bill  sold  to  a  reserve  bank.  But  it  was  to  be  required  as  a 
basis  of  permanent  procedure  that  the  original  borrower 
should  file  such  a  statement  with  his  member  bank.  For 
the  time  being,  certified  accountants'  statements  need  not 
be  submitted.  It  was  suggested,  however,  that  at  a  later 
date  these  might  be  required.   Even  though  the  statement 


84  FEDERAL  RESERVE  POLICY 

of  condition  need  not  be  attached  to  each  bill,  the  paper 
must  bear  on  its  face  evidence  that  it  was  eligible,  and  that 
the  seller  had  filed  a  statement  of  condition  with  the  mem- 
ber banks.  This  evidence  might  be  vouchsafed  by  the 
officers  of  the  member  applying  bank  through  the  means 
of  a  rubber  stamp. 

These  regulations  were  exceedingly  exacting,  so  far,  at 
least,  as  methods  of  procedure  were  concerned.  Few  of  the 
smaller  banks,  particularly  those  in  the  rural  sections,  were 
in  position  to  supply  the  required  evidence  that  a  satisfac- 
tory statement  of  condition  was  on  file.  In  the  face  of  an 
almost  entire  lack  of  rediscounting,  it  soon  appeared  that 
the  severity  of  these  regulations  must  be  relaxed.  Accord- 
ingly, on  January  12,  19 15,  three  days  before  these  regula- 
tions were  to  become  effective,  the  Board  extended  the 
date  from  January  15  to  July  15  of  the  same  year.  But  the 
lack  of  a  genuine  desire  to  rediscount  still  asserted  itself 
and  in  Regulation  B,  Series  of  1915/  it  was  ruled  that 
statements  of  condition  need  not  be  on  file  in  certain  types 
of  borrowing  where  it  was  believed  it  would  be  difficult  to 
obtain  them.  To  be  specific,  these  requirements  were  to  be 
waived : 

1.  If  the  bill  bears  the  signature  of  the  purchaser  and  seller 
of  the  goods  and  presents  prima  facie  evidence  that  it  was  issued 
for  goods  actually  purchased  or  sold ;  or 

2.  If  the  aggregate  amount  of  obligations  of  such  a  depositor 
actually  rediscounted  and  offered  for  rediscount  does  not  exceed 
$5000,  but  in  no  event  a  sum  in  excess  of  10  per  centum  of  the 
paid-in  capital  of  the  member  bank;  or 

3.  If  the  bill  be  specifically  secured  by  approved  warehouse 
receipts  covering  readily  marketable  staples. 

In  succeeding  circulars  regulations  with  a  similar  trend 
were  sent  out.  In  view  of  the  very  great  desire  of  the  Board 
to  improve  the  admitted  deplorable  conditions  in  the  trade 

'  See  Bulletin,  May  i,  1915,  pp.  37-38. 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS  85 

and  bank  credit  situation,  it  appears  to  the  writer  that  the 
Board  cannot  be  convicted  of  endeavoring  to  establish 
ultra-bureaucratic  methods  of  procedure. 

The  purposes  of  the  Board's  regulations  were  two-fold. 
First,  they  were  designed  to  state  the  precise  terms  accord- 
ing to  which  the  more  general  terms  of  the  statute  could  be 
made  applicable  to  individual  cases;  and,  second,  to  lay 
down  rules  governing  rediscount  operations  in  cases  where 
the  statute  appeared  to  be  silent.  But  even  the  regula- 
tions themselves  could  not  be  expected  to  deal  specifically 
with  the  multitude  of  complicated  cases  which  must 
inevitably  arise.  Accordingly,  as  a  means  of  disseminating 
such  information,  the  Board  began  the  publication  in  its 
official  organ,  the  Federal  Reserve  Bulletin,  issued  monthly 
first  of  its  own  informal  rulings,  and  second  of  the  opinions 
of  counsel  in  the  Law  Department.  In  these  we  find  replies 
to  the  inquiries  of  member  banks,  reserve  bank  officials, 
private  individuals,  and  governmental  representatives.  By 
these  methods  much  was  accomplished  in  the  way  of  har- 
monizing the  policies  of  the  various  district  board  direc- 
torates. To  a  very  marked  extent  the  wisdom  or  lack 
of  wisdom  of  the  Board's  policies  is  set  forth  in  these 
pronouncements. 

The  difificulties  of  avoiding  confusion  and  inconsisten- 
cies in  these  rulings  are  easily  apparent.  To  consider  that 
prime  difficulty  of  fundamental  application  —  when  is  an 
operation  commercial  and  when  is  it  merely  investment  in 
character?  A  distinction,  such  as  this  would  involve,  could 
not  be  set  up  by  any  generally  accepted  method  of  eco- 
nomic reasoning.  Fundamentally  this  cjucry  touches  a  prob- 
lem which  has  never  been  withdrawn  from  the  field  of 
theoretical  economic  controversy  —  what  is  capital?  Ever 
since  the  precepts  of  the  science  of  economics  have  been 
formulated  systematically,   the  masters  have  quarreled 


86  FEDERAL  RESERVE  POLICY 

over  the  proper  means  of  delimiting  this  concept.  To-day 
opposite  viewpoints  are  still  displayed.  One  school  would 
define  capital  from  the  point  of  view  of  the  form  of  the 
good  —  whether  or  not  it  is  of  a  kind  primarily  applicable 
to  the  creation  of  other  consumable  goods.  The  other 
school  would  define  solely  from  the  acquisitive,  individual- 
istic point  of  view.  Thus  capital  comprises  those  goods,  no 
matter  what  the  form,  which  are  employed  not  to  provide 
direct  psychic  income,  but  rather  to  enable  the  possessor 
better  to  derive  a  money  income.  This  fundamental  diffi- 
culty appears  again  and  again  in  the  determination  of 
eligible  paper. 

Many  less  far-reaching  criteria  were  current  also  in  19 14 
regarding  the  proper  definition  of  commercial  paper.  One 
of  these  was  this  —  it  is  paper  the  proceeds  of  which  are 
employed  in  order  to  acquire  readily  salable  goods.  The 
note  of  the  coal  dealer  to  secure  the  funds  for  the  purchase 
of  coal  to  be  speedily  resold  to  his  customers,  of  the  fruit 
buyer  to  acquire  fruit  for  his  current  sales,  would  be  eligi- 
ble commercial  paper.  But  what  about  paper  arising  in 
the  individual's  desire  to  acquire  tracts  of  standing  timber? 
The  timber  as  well  as  the  timber  land  might  be  sold  speed- 
ily, yet  the  individual  owner. might  have  in  mind  more  or 
less  permanent  ownership.  The  nature  of  his  possession 
might  create  no  hardship  in  holding  permanently.  Unlike 
the  coal  or  the  fruit,  the  timber  would  continue  to  improve 
in  physical  quantity.  There  would  be  much  more  likelihood 
of  its  being  held  indefinitely  than  in  the  case  of  the  coal  or 
of  the  fruit.  But  should  the  paper  be  refused  merely 
because  the  asset  of  the  borrower  and  accordingly  the 
security  for  the  bank  improves? 

In  this  case  the  existence  of  another  quality  of  standing 
tracts  of  timber  rendered  more  easy  a  statement  of  the 
Board's  opinion.    This  extraneous  quaUty  enabled   the 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS  87 

Board  to  base  its  ruling  on  the  desirability  of  preserving 
liquid  the  banks'  assets.  Timber  is  subject  to  forest  fires 
and  severe  winds.  To  quote  from  the  Bulletin  for,  July  i, 
1915:' 

While  it  is  true  that  there  are  times  when  timber  lands,  that 
have  been  thoroughly  cruised  and  reported  upon  by  competent 
experts,  are  readily  salable,  there  are  other  conditions  relating 
to  properties  of  this  kind  which  must  be  taken  into  considera- 
tion. Forest  fires  sometimes  destroy  a  good  deal  of  standing 
timber,  and  sometimes  wind  storms  greatly  diminish  the  value 
of  such  properties. 

The  precedent  would  be  a  dangerous  one,  as  owners  of  coal 
and  ore  lands  might  ask  to  have  their  coal  and  ore  in  the  grounds 
appraised  on  a  royalty  basis,  and  ask  to  have  paper,  based  upon 
their  holdings  of  such  lands,  made  eligible  for  discount  at  Federal 
reserve  banks. 

But  without  the  possibility  of  relying  upon  this  quality 
of  timber  land  —  possibility  of  great  deterioration  in  physi- 
cal quality  —  how  much  more  difficulty  must  have  at- 
tended the  ruling? 

Let  us  therefore  suppose  another  case  in  which  no  such 
condition  exists.  What  if  the  contractor  wishes  to  borrow 
in  order  to  secure  funds  for  the  erection  of  a  building?  Is 
his  operation  commercial,  or  investment,  or  even  specula- 
tive in  its  nature? 

Here  again  the  Board  Wcis  enabled  to  rely  upon  a  fact  of 
attending  circumstance  —  whether  or  not  at  the  time  of 
borrowing  the  contractor  possessed  a  contract  of  sale. 
Thus  we  are  informed  by  the  Bulletin  for  July,  1920,'  that 
the  proceeds  are  for  fixed  improvements  and  the  note  is 
ineligible  in  case  the  paper  is  that  of  the  owner.  But  if  it  is 
that  of  the  contractor,  it  may  be  regarded  as  commercial  in 
character.  Thus  another  quality  of  paper  is  introduced  — 

•  Page  126. 
'  Page  699. 


88  FEDERAL  RESERVE  POLICY 

existence  of  contract  for  vsale  of  that  which  has  been  ac- 
quired or  constructed  by  the  use  of  the  proceeds  of  the 
borrowing. 

But  if  intention  to  liquidate  quickly  is  the  uniform  cri- 
terion, the  Board  must  face  another  difficulty  —  one  which 
must  occasion  frequent  discontent  with  the  management 
of  the  system.  One  borrower  might  be  the  maker  of  an 
eligible  note,  another  of  an  ineligible  note,  even  though  in 
both  cases  the  proceeds  were  employed  to  purchase  the 
same  sort  of  a  good.  In  one  case  the  Board  held  eligible  a 
farmer's  note  to  secure  the  funds  for  the  purchase  of  farm 
tractors.  Using  this  as  a  precedent,  it  was  insisted  ^  by  a 
corporation  engaged  in  the  business  of  furnishing  motor 
transportation  that  its  notes  to  secure  funds  with  which  to 
purchase  motor  trucks  were  eligible.  This  corporation  ar- 
gued that  its  paper  was  even  superior  to  that  of  the  farmer 
since  the  life  of  a  motor  truck  ordinarily  is  less  than 
that  of  a  farm  tractor.  Motor  truck  paper  would  be  less  of 
an  investment  nature  than  tractor  paper.  Accordingly  the 
Board  is  here  compelled  to  make  a  distinction  dependent 
entirely  upon  a  matter  of  degree.  To  quote  a  part  of  its 
ruling: 

Farm  tractors  constitute  only  a  small  part  of  the  entire 
equipment  of  a  farm,  whereas  the  motor  trucks  of  a  corporation 
engaged  in  the  business  of  furnishing  motor  transportation 
necessarily  constitute  a  very  large  part  of  the  corporation's 
entire  equipment.  If  the  notes  of  such  a  corporation,  the  pro- 
ceeds of  which  are  used  to  purchase  motor  trucks,  were  declared 
eligible  for  rediscount  by  Federal  Reserve  Banks,  the  result 
would  be  that  paper  representing  in  the  aggregate  a  very  large 
part  of  the  corporation's  capital  investment  would  be  eligible 
for  rediscount,  and  it  would  not  be  reasonable  to  assume  that 
such  notes  could  be  liquidated  out  of  the  corporation's  current 
revenues. 

'  Bulletin,  February,  192 1,  p.  191. 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS  89 

Obviously  the  task  of  deciding  what  is  and  what  is  not  a 
fixed  investment  is  fraught^with  difficulty.  Frequently  the 
decisions  do  not  meet  the  issue  squarely.  Dependence  upon 
facts  of  attendant  circumstance  must  make  future  rulings 
largely  a  matter  of  following  precedent,  with  the  danger  of 
confusion,  inconsistencies,  and  reliance  upon  arbitrary, 
discretionary  judgment. 

But  to  summarize  our  conclusions  as  reached  thus  far 
"readily  salable  goods"  is  not  a  concept  easily  determined 
and  easily  applied.  In  some  cases  conclusions  must  depend 
upon  the  risks  of  deterioration ;  in  others,  upon  the  exist- 
ence of  contracts  to  sell.  In  others,  it  would  seem  to  depend 
upon  the  extent  to  which  the  value  of  the  goods  acquired 
by  the  proceeds  of  the  borrowing  measure  up  to  that  of  the 
other  assets  of  the  company.  Fortunately  for  the  Board, 
the  provisions  of  the  statute  inserted  the  word  mere  in  the 
prohibitory  clause  relating  to  investment  paper. 

Let  us  next  consider  another  basis  for  determining  the 
eligible  character  of  the  paper.  Are  the  proceeds  to  be 
employed  to  further  some  definite  stage  of  production, 
distribution,  or  manufacture?  If  the  proceeds  are  not  to  be 
employed  in  such  a  way  as  to  hasten  their  journey  toward 
acquirement  by  the  ultimate  consumer,  clearly  the  expendi- 
tures were  for  capital  and  not  for  commercial  purposes. 
But  in  practice  it  must  be  very  difficult  to  determine 
whether  a  given  operation  is  a  necessary  part  of  the  process 
of  production  or  commerce.  How  classify  the  note  of  the 
dealer  who  borrows  in  order  to  acquire  grain  or  cotton 
which  for  the  time  being  at  least  Is  not  to  be  sold?  Is  mere 
warehousing  to  be  considered  a  necessary  part  of  the  dis- 
tribution process?  If  it  is  thus  to  be  considered,  would  not 
dangerous  precedents  be  developed,  precedents  which 
might  seem  to  justify  Federal  Reserve  advances  for  com- 
modity speculation  ?  What  if  the  purpose  of  the  borrower 


90  FEDERAL  RESERVE  POLICY 

was  primarily  to  put  himself  in  a  position  to  create  a  tem- 
porary scarcity  by  withholding  the  goods  from  the  market? 

No  practice  in  market  distribution  is  more  frowned  upon 
by  the  public  than  commodity  speculation  of  this  sort.  In 
our  recent  period  of  unrest  over  the  rising  cost  of  living, 
much  legislation  and  many  administration  measures  were 
directed  against  devices  of  this  sort.  Nevertheless,  loans 
to  store  goods  are  very  essential  to  the  marketing  of  many 
crops.  The  supply  appears  suddenly  on  the  market,  and  if 
credit  cannot  be  obtained  by  the  grower,  the  crop  must  be 
sacrificed  at  depressed  prices.  The  purchasers,  presum- 
ably often  in  a  better  position  to  obtain  bank  capital, 
would  then  be  in  as  good  a  position  as  the  local  dealer  to 
withhold  from  sale  for  the  sake  of  influencing  the  price 
unduly.  Rejection  of  applications  based  on  paper  of  this 
sort  woula  seem  to  create  injustices  as  between  different 
classes  of  grain  dealers. 

It  is  obvious  that  the  ideal  solution  would  be  for  the 
Board  to  be  guided  by  the  existing  situation  In  the  market 
and  not  by  any  easily  ascertainable  fact  of  the  paper.  As 
long  as  the  goods  are  not  unduly  obstructed  in  their  flow 
to  the  market,  the  reserve  advances  appear  to  be  justified. 
In  the  words  of  the  Board,  the  test  is  whether  the  funds  are 
requested  in  order  to  facilitate  the  orderly  and  regular 
marketing  of  the  crops.  Thus  in  the  Bulletin  for  December 
I,  1919,^  we  read  of  certain  remarks  addressed  to  cotton 
growers : 

The  Board  has  consistently  advocated  during  the  past  five 
years  the  policy  of  orderly  marketing  of  crops.  Assuming  that 
adequate  warehousing  facilities  are  available,  it  seems  to  be  in 
the  interest  of  the  consumer  as  well  as  of  the  producer  that  staple 
commodities  remain  as  far  as  possible  in  the  hands  of  producers 
until  sold  for  consumption.  This  policy  gives  the  producer  the 
benefit  of  an  average  price  In  that  he  is  not  required  to  "dump" 
'Page  1 109. 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS  91 

his  products  upon  the  market  in  excessive  volume,  thereby 
depressing  the  price  to  the  advantage  of  favored  consumers  or 
of  speculators  who  do  not  as  a  rule  pass  the  advantage  on  to  the 
consumer.  Owing  to  the  great  number  of  producers  there  will 
always  be  competition  between  them  to  sell,  which  would  not 
be  the  case  if  large  syndicates  were  able  to  acquire  control  of  the 
bulk  of  the  crop. 

But  no  matter  how  wide  the  difference  in  results  between 
speculative  borrowing  and  those  necessary  for  the  orderly 
moving  of  the  crops,  the  determination  of  the  precise  situa- 
tion can  never  be  easy.  The  eligibility  of  any  single  note 
must  depend  upon  general  market  and  business  conditions. 
Under  some  situations  the  note  of  a  grain  dealer  should  be 
accepted;  under  other  situations  the  note  of  the  same 
dealer  for  an  identically  similar  purpose  must  be  rejected. 
Day-to-day  considerations  must  govern. 

What  help  can  be  obtained  by  following  through  another 
criterion?  Were  the  proceeds  originally  employed  in  order 
to  purchase  goods  in  form  fairly  complete,  or  close  to  the 
point  where  marketable?  Or,  on  the  other  hand,  were  the 
proceeds  invested  in  goods  which  must  be  completely 
altered  in  form  in  order  to  render  marketable?  If  this  be 
the  basis  of  distinction,  the  reserve  funds  must  render  less 
aid  to  the  production  and  industrial  than  to  the  distribu- 
tive interests  of  society.  Coal  purchased  by  a  gas  company 
is  not  to  be  marketed  until  completely  altered  in  form. 
Labor  purchased  by  an  electric  light  company  emerges  in 
salable  condition  only  in  form  of  electric  current.  But 
might  not  the  note  of  the  gas  company  be  just  as  liquid 
when  the  proceeds  are  used  to  purchase  coal  as  the  note  of 
a  grain  dealer  to  secure  funds  for  acquiring  grain?  Is  not 
the  pay-roll  expense  of  the  electric  light  company  as 
speedily  contributory  to  income  as  the  expenditure  of  the 
grocery  dealer  for  canned  goods?  The  labor  employed  is 
not  sold,  but  the  products  speedily  are.    It  is  evident  that 


92  FEDERAL  RESERVE  POLICY 

little  aid  is  to  be  obtained  by  focusing  attention  upon  the 
form  of  the  goods  purchased  by  the  proceeds  of  the  note. 

Shall  another  criterion  be  accepted  —  the  speed  with 
which  the  borrower  should  be  able  to  liquidate  his  loan? 
Shall  it  be  the  shortness  of  the  period  within  which  the 
expenditures  bring  in  returns  which  determines  eligibility? 
Should  reserve  funds  be  withheld  from  operations,  in  all 
other  respects  as  commercial  as  any  other,  in  which  for 
technical  reasons  a  longer  period  than  ninety  days  is 
required?  It  is  evident  that  such  a  course  would  involve 
much  partiality.  As  stated  in  the  Bulletin  for  June  i,  1915 :  '^ 

There  are  many  processes  of  production  which  take  a  longer 
time  than  90  days,  and  while  no  Federal  Reserve  Bank  should 
enter  into  an  agreement  for  the  renewal  of  discounted  paper, 
nevertheless,  in  cases  where  the  "process  of  production"  dis- 
tribution covers  a  period  longer  than  90  days,  there  is  no  reason 
why  a  borrower  should  not  renew  his  90  day  borrowing. 

In  general,  as  stated  in  another  connection,  "  Liquidity  should 
not  be  tested  by  standards  that  are  too  narrow,  arbitrary  or 
inflexible." 

It  thus  appears  that  no  one  yardstick  is  available  in 
determining  the  eligible  character  of  the  paper  offered  for 
rediscount.  Neither  liquidity,  nor  existence  of  a  contract 
to  sell  the  product,  nor  the  form  of  the  goods  acquired  by 
the  proceeds  of  the  borrowing,  nor  the  probable  speed  of 
liquidation,  alone,  is  sufficient.  Distinction  between  eli- 
gible and  ineligible  paper  must  often  depend  upon  mere 
matters  of  degree  or  emphasis.  Differences  are  often  only 
relative.  It  is  pertinent  to  inquire,  therefore,  whether  in 
the  original  act  it  was  not  somewhat  futile  to  place  so  much 
emphasis  upon  the  commercial  character  of  the  paper.  Are 
the  distinctions  between  commercial  and  non-commercial 
paper  too  difficult  to  employ  consistently  in  practice? 
Should  discriminations  have  been  waived   and   certain 

'  Page  74. 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS  93 

types  of  investment  paper  rendered  admissible?  Queries 
such  as  these  must  be  postponed  until  a  later  chapter.  But 
this  much  is  now  clear:  under  the  present  regulations  much 
reliance  must  be  placed  upon  the  discretionary  judgment, 
first  of  the  member  bank,  second  of  the  reserve  bank  direc- 
torate, and  lastly  of  the  Federal  Reserve  Board.  If  this  be 
true,  it  appears  desirable  to  inquire  whether  other  means  of 
restricting  the  unwise  use  of  reserve  bank  facilities  were 
contained  or  should  have  been  contained  in  the  statute. 

One  obvious  method  of  preventing  excessive  use  of 
reserve  funds  would  be  to  limit  the  amount  of  rediscounts 
obtainable  by  any  one  member  institution.  Since  all  mem- 
ber banks  contribute  to  the  resources  of  the  reserve  banks 
according  to  their  capital  and  surplus,  their  rediscounting 
privileges  might  be  determined  on  the  same  basis.  In  this 
way  an  outside  limit  could  be  placed  on  the  extent  to 
which  any  one  bank  could  rely  upon  the  reserve  facilities, 
and  any  one  bank  could  be  prevented  from  using  funds 
so  excessively  as  to  diminish  the  power  of  reserve  banks 
to  render  aid  to  other  member  institutions  in  periods  of 
emergency. 

Such  a  restriction  did  not  commend  itself  to  the  framers 
of  the  act.  It  is  true  that  another  statute'  prevents  a 
national  bank  from  incurring  certain  indebtedness  in  excess 
of  its  capital  stock.  But  to  the  application  of  this  law  there 
are  certain  exceptions.  One  of  these  exceptions  "^  relates  to 
any  indebtedness  incurred  under  the  provisions  of  the  Re- 
serve Act.  It  has  accordingly  been  ruled  that  a  member 
bank  may  rediscount  paper  to  any  amount  permitted  by  the 
district  directorate.  1 1  was  felt  that  in  periods  of  emergency 
the  power  of  the  district  board  to  render  relief  should  not 
be  curtailed.    In  periods  of  business  confidence,  it  was 

'  Section  5202  of  the  Revised  Statutes. 
'  See  section  13,  Federal  Reserve  Act. 


94  FEDERAL  RESERVE  POLICY 

believed  that  most  reliance  should  be  placed  upon  the 
good  judgment  of  the  district  bank  directorate.  Restric- 
tion of  rediscounts  for  any  one  bank  is  accordingly  a  matter 
of  the  discretionary  power  of  management. 

A  second  plan  would  be  to  restrict  the  amount  of  redis- 
countable  paper  bearing  the  signature  of  any  one  party. 
Such  a  limitation  might  appear  to  be  much  more  equitable. 
Should  one  borrower  of  one  bank  be  refused  accommoda- 
tions at  a  time  when  the  paper  of  another  no  more  deserv- 
ing borrower  of  another  bank  is  admitted?  Should  not 
discriminations  take  account  of  facts  of  justice  between 
individuals,  rather  than  primarily  between  banks?  Acting 
on  this pointof  view, theframersofthestatuteprohibited  the 
rediscount  of  paper  bearing  the  signature  of  the  same  name, 
provided  such  paper  exceeds  ten  per  centum  of  the  unim- 
paired capital  and  surplus  of  the  lending  bank.  To  this 
general  statement  exceptions  are  to  be  made  in  case  of 
"bills  of  exchange"  drawn  in  good  faith  against  actually 
existing  values.  Furthermore,  in  order  to  encourage  the 
purchase  and  acquirement  of  war  securities  an  act  of  lim- 
ited duration  was  enacted,  according  to  which,  on  April  i6, 
19 19,  the  Board  ruled  it  permissible  for  a  reserve  bank  to 
rediscount  paper  of  a  single  borrower  to  an  amount  equal- 
ing twenty  per  cent  of  the  capital  and  surplus  provided  the 
excess  above  ten  per  cent  was  secured  by  a  like  face  amount 
of  Liberty  bonds  or  certificates  of  indebtedness.^ 

But  would  the  paper  of  any  borrowing  individual  redis- 
counted  with  the  reserve  bank  be  included  within  the 
limitations  of  section  5200  of  the  Revised  Statutes. 
Would  the  creditor  be  considered  to  be  the  member  bank 
or  the  reserve  bank?  In  view  of  the  fact  that  rediscounts 
must  be  endorsed  by  the  member  bank,  and  accordingly 
comprise  a  contingent  liability  of  the  bank,  a  good  case 

'  Cf.  Commercial  and  Financial  Chronicle,  April  19,  1919,  p.  1561. 


ADVANCES  OF  RESERVE  BANKS— REDISCOUNTS  95 

would  seem  to  exist  for  regarding  them  in  this  light.  But 
by  an  Opinion  of  Counsel  it  was  ruled  in  the  Bulletin  for 
September  i,  191 8,  that: ' 

A  note  or  bill  rediscounted  in  good  faith  by  a  member  bank 
which  is  no  longer  owned  or  held  by  the  bank  need  not  be  in- 
cluded as  a  liability  of  the  maker  to  the  bank  within  the  meaning 
of  section  5200,  Revised  Statutes. 

The  effect  of  this  opinion  is  to  confirm  the  view  that 
rediscounting  offers  a  process  by  which  a  bank  may  increase 
greatly  its  loans  to  any  one  client.  In  case  the  paper  of  any 
one  borrower  approaches  the  ten  per  cent  limit,  such 
paper  may  be  rediscounted.  In  this  case  it  becomes  an 
obligation,  not  to  the  member,  but  to  the  reserv^e  bank. 

A  consideration  of  these  various  limitations  perhaps 
justifies  this  general  conclusion :  provided  a  member  bank 
possesses  a  sufficient  quantity  of  rediscountable  paper, 
effective  limitation  of  the  rediscounts  must  depend  almost 
solely  on  the  good  judgment  of  the  district  directorate  and 
the  Federal  Reserve  Board.  Restraints  of  a  direct  nature, 
arbitrary  refusals  to  accept  the  applications  of  certain 
classes  of  paper,  depend  largely  upon  the  reserve  director- 
ates. Indirect  restraint,  those  relating  to  the  cost  of  redis- 
counting, depend  ultimately  upon  the  Board,  because  of 
its  power  to  review  rates  of  rediscount.  The  development 
of  the  reserve  system  is  thus  largely  a  story  of  manage- 
ment. Statutory  provisions  reduce  themselves  in  large 
measure  to  the  discretionary  judgment  of  direction.  The 
most  important  restrictions  relate  to  the  prohibitions  on 
speculative  and  investment  paper.  But  for  the  most  part 
the  Board's  rulings  and  regulations  have  been  exceedingly 
liberal. 

It  was  not  contemplated  by  the  framers  of  the  act  that 
reserve  banks  should  lend  their  facilities  to  nnn -member 

'  Page  867. 


96  FEDERAL  RESERVE  POLICY 

institutions.  These  banks  were  not  rendered  subject  to 
examination  by  the  Federal  Reserve  Board  and  make  no 
contribution  to  the  capital  of  the  reserve  institutions.  To 
rediscount  this  paper  must  destroy  one  of  the  principal 
incentives  to  membership  in  the  Federal  Reserve. 

What,  however,  was  enacted  about  indirect  means  of 
securing  the  use  of  reserve  funds?  Could  not  the  member 
bank  accept  the  paper  of  non-member  institutions  and  by 
rediscounting  this  paper  free  its  own  resources?  In  this 
way  the  reserve  could  be  made  the  indirect  source  of 
advances  to  non-member  institutions. 

It  was  felt  by  the  lawmakers  that  this  would  be  a  situa- 
tion necessitating  much  discrimination  in  judgment.  On 
some  occasions  it  might  be  a  service  to  member  banks  for 
reserve  banks  to  aid  non-members  in  this  indirect  way.  Such 
action  might  be  the  means  of  restoring  general  business 
confidence.  In  other  situations,  however,  such  advances 
might  not  be  necessary  and  might  have  the  sole  effect 
of  discouraging  membership  in  the  system.  Accordingly, 
the  law  requires  that,  in  case  the  purpose  of  such  applica- 
tions was  to  secure  funds  to  reloan  non-member  banks,  the 
permission  of  the  Federal  Reserve  Board  must  be  obtained. 
During  the  war  period,  however,  matters  of  Government 
finance  were  deemed  sufficient  to  warrant  a  very  liberal 
application  of  the  statute.  For  a  certain  period  it  was  left 
to  the  discretion  of  the  district  bank  directorates  to  deter- 
mine whether  such  accommodations  should  be  afforded  the 
non-member  institutions.^ 

'  Cf.  Bulletin,  June  i,  1917,  p.  426. 


CHAPTER  V 

DIRECT  COLLATERAL  ADVANCES  TO  MEMBER 
BANKS 

When  the  Federal  Reserve  system  began  operations  in  the 
fall  of  19 14,  advances  could  not  be  made,  under  the  author- 
ity of  section  13,  by  direct  discounts  of  member  banks' 
notes.  Leaving  out  of  account  their  open-market  opera- 
tions, reserve  banks  could  grant  accommodations  only 
upon  the  tender  of  paper  which  had  originated  previously 
in  an  advance  by  the  member  bank  to  one  of  its  clients. 
In  other  words,  the  reserve  bank's  portfolio  would  consist 
of  paper,  the  makers  of  which  were  the  customers  of  the 
member  bank.  For  the  sake  of  ensuring  the  safety  of  this 
paper  and  accordingly  of  the  soundness  of  the  reserve 
banks'  assets,  member  banks  were  required  to  endorse  the 
paper  offered  for  rediscount.  But  the  member  banks'  re- 
sponsibility was  contingent  and  not  direct. 

The  reasons  motivating  the  lawmakers  to  discriminate 
against  direct  discounts  were  several.  In  the  first  place,  the 
paper  accepted  would  be  single  —  and  not  double-name. 
Only  the  member  bank  would  be  responsible  for  ultimate 
payment;  whereas  in  the  case  of  a  rediscount,  the  member 
bank's  contingent  responsibility  would  be  additional  to 
that  of  the  original  borrower.  Secondly,  rediscounting 
operations  emphasized  more  strongly  the  direct  public 
benefits  which  the  reserve  system  was  intended  to  accom- 
plish. In  case  of  a  direct  discount  for  a  bank,  it  might  be 
difficult  for  many  to  understand  just  how  the  business  pub- 
lic was  being  aided ;  whereas  in  the  case  of  a  rediscount  the 


98  FEDERAL  RESERVE  POLICY 

ability  of  a  bank  to  finance  a  specific  transaction  would 
seem  to  depend  more  directly  upon  the  willingness  of  the 
reserve  bank  to  accept  such  paper.  Rediscount  operations 
appeared  to  bring  the  reserve  banks  more  closely  in  con- 
tact with  the  public.  Finally,  it  was  feared  that  direct 
advances  might  be  dangerous.  If  the  member  bank  pos- 
sessed short-time  eligible  paper,  it  could  secure  aid  through 
rediscounts;  in  case  it  possessed  no  such  paper,  its  purpose 
very  likely  would  be  to  secure  capital  for  long-time  com- 
mitments. To  refuse  to  make  direct  advances  would  not 
seem  to  penalize  the  institution  which  held  paper  of  the 
eligible  sort.  But  it  would  penalize  the  bank  whose  assets 
consisted  largely  of  investment  or  speculative  paper. 
Applications  for  direct  discounts  would  be  the  resource  of 
those  institutions  which  did  not  possess  eligible  paper,  and 
whose  assets,  therefore,  were  presumably,  non-liquid. 

Of  these  various  objections,  the  last  was  apparently  the 
most  impressive.  For  one  illustration  we  may  quote  the 
following  extracts  from  the  reply  of  John  Perrin,  Chairman 
of  the  San  Francisco  Reserve  Bank,  to  the  appeals  of  the 
Orange  County  Bankers'  Association  of  California  for  an 
amendment  to  the  act  which  would  permit  direct  discounts 
of  member  banks'  paper  :^ 

Bank  reserves  under  requirements  of  the  old  system  were  at 
times  found  inadequate  and  financial  panic  resulted.  Your 
resolution  seems  to  us  to  advocate  not  only  a  continuance  of  the 
evils  of  the  old  system,  but,  in  advocating  loans  of  indift'erent 
liquidity  out  of  diminished  reserves,  urges  a  further  weakening. 
It  would  seem  to  us  that  no  policy  could  be  more  suicidal  and 
none  more  certain  to  involve  both  the  banks  and  their  custom- 
ers in  disaster.  .  .  . 

The  development  of  liquid  commercial  paper  is  a  fundamental 
essential  of  banking  progress.  In  lowering  reserve  requirements 
the  Federal  Reserve  Act  contemplates  that  a  bank's  paper 

»  See  Commercial  arid  Financial  Chronicle,  January  22,  1916,  p.  300. 


COLLATERAL  ADVANCES  TO  MEMBER  BANKS  99 

eligible  for  rediscount  with  Federal  Reserve  bank  will  consti- 
tute an  important  part  of  its  real  reserve.  This  fortification 
your  resolution  would  sweep  aside,  though  it  should  be  clear 
that  while  the  Federal  Reserve  bank  may  convert  shortly  matur- 
ing liquid  paper  into  means  of  payment  it  has  no  power  to  con- 
vert a  non-liquid  loan  into  one  which  will  speedily  convert  itself 
into  a  money  reserve. 

If  direct  discounts  should  be  made  to  members  who  did 
not  possess  the  necessary  amount  of  eligible  short-time 
paper,  the  truth  of  the  above  statement  would  be  clear. 
But  might  not  a  member  bank  desire  frequently  to  offer 
its  own  note  even  though  its  portfolio  did  contain  liquid 
admissible  paper?  Might  not  a  bank  find  direct  discounts 
more  convenient  and  feasible?  An  afifirmative  answer  to 
this  query  might  be  based  on  the  following  grounds: 

(a)  The  member  bank  might  wish  to  borrow  for  very 
short  periods  of  time.  To  discount  customers'  paper  of 
longer  maturity  would  subject  the  applying  bank  to  the 
heaviest  discount  applying  to  the  paper  with  longer  matur- 
ity. Rather  than  submit  to  this  heavier  charge,  the  coun- 
try bank,  in  particular,  might  continue  to  seek  aid  from 
its  city  correspondent  instead  of  applying  to  the  reserve 
bank.  Such  action  would  render  it  all  the  more  difficult  for 
the  reserve  system  to  extend  its  membership  and  improve 
its  prestige  and  power  to  regulate  the  money  market. 

(b)  In  the  second  place,  it  was  argued  that  direct  dis- 
counts woulcl  reduce  greatly  the  labor  of  computing  inter- 
est on  many  small  notes.  Discounts  would  have  to  be 
figured  only  on  the  member's  note;  when  this  note  fell 
due,  it  could  be  paid  off  and  the  collateral,  consisting  per- 
haps of  customers'  paper  of  various  maturities,  could  be 
returned. 

(c)  In  the  third  place,  direct  advances  collateralod  by 
customers'  notes  could  be  made  to  ofTer  some  margin  of 
security  to  the  reserve  bank.  The  face  value  of  the  collat- 


100  FEDERAL  RESERVE  POLICY 

eral  could  be  made  higher  than  the  amount  of  the  advance. 
In  the  case  of  an  uncollateralcd  rediscount,  there  could  be 
no  margin  of  security  over  the  advance  of  the  reserve 
bank. 

With  the  lessons  of  experience  thus  indicating  that  di- 
rect discounts,  properly  regulated,  could  be  supported  by 
arguments  relating  to  safety  as  well  as  to  those  of  conve- 
nience, a  general  demand  arose  for  a  change  in  the  statute. 
Accordingly,  on  September  7,  1916,  an  amendment  to  the 
Reserve  Act  was  passed  according  to  which  such  advances 
were  to  be  permitted  in  cases  where  the  member  bank's 
note  was  limited  to  fifteen  days'  maturity  and  in  cases 
where  the  collateral  consisted  either  of  the  kind  of  paper 
eligible  for  rediscount  or  of  Government  securities.  The 
specific  wording  of  this  amendment  was  as  follows :  * 

Any  Federal  reserve  bank  may  make  advances  to  its  member 
banks  on  their  promissory  notes  for  a  period  not  exceeding 
fifteen  days  at  rates  to  be  established  by  such  Federal  reserve 
banks,  subject  to  the  review  and  determination  of  the  Federal 
Reserve  Board,  provided  such  promissory  notes  are  secured  by 
such  notes,  drafts,  bills  of  exchange,  or  bankers'  acceptances 
as  are  eligible  for  rediscount  or  for  purchase  by  Federal  reserve 
banks  under  the  provisions  of  this  Act,  or  by  the  deposit  or 
pledge  of  bonds  or  notes  of  the  United  States. 

The  reasons  for  the  inclusion  of  the  several  restrictions 
on  direct  collateral  advances  should  be  cleart  Unless  the 
objection  of  rendering  the  reserve  assets  more  non-liquid 
was  to  hold,  member  banks  should  possess  paper  of  an 
eligible  sort.  If  they  held  such  paper,  it  would  be  no  hard- 
ship to  require  them  to  forward  it  as  collateral  for  the  ad- 
vance. The  basis  of  limiting  the  maturity  of  the  member's 
note  seems  obvious,  likewise.  If  the  previous  difficulty 
was  need  of  funds  for  a  period  shorter  than  the  maturities 

'  See  section  13  of  the  amended  act. 


COLLATERAL  ADVANCES  TO  MEMBER  BANKS    loi 

of  customers'  paper,  member  banks  could  not  object  to 
the  limitation  of  fifteen  days  for  the  period  of  advance. 

After  the  date  of  the  amendment,  the  advantages  of 
direct  borrowing  frequently  proved  appealing  aside  from 
considerations  of  convenience.  In  the  seven  months  or  so 
preceding  the  outbreak  of  hostilities,  the  reserve  adminis- 
tration continued  to  stress,  as  a  means  of  preparation  for 
any  future  emergency,  the  desirability  of  maintaining  the 
liquid  character  of  the  reserve  system's  assets.  Fifteen- 
day  paper  accordingly  was  much  in  demand  by  the  reserve 
banks.  After  the  outbreak  of  the  war,  direct  loans  collat- 
eraled  by  Government  securities  rendered  great  aid  in  the 
Treasury's  war  finance  policy.  Prior  to  September  7,  1916, 
member  banks  which  might  have  acquired  Government 
bonds  could  not  liquidate  them  by  means  of  rediscount 
operations.  It  is  true  that  customers'  paper,  the  proceeds 
of  which  had  been  used  to  purchase  Government  bonds, 
was  eligible.  But  in  the  Treasury's  war  finance  campaign 
it  proved  necessary  frequently  to  rely  heavily  upon  the 
subscriptions  of  the  member  banks  themselves.  To  guar- 
antee banks  against  loss  through  the  fact  that  the  bond 
subscriptions  might  temporarily  drain  them  of  funds,  mem- 
ber banks  were  permitted  to  discount  their  own  notes  col- 
lateraled  by  Government  war  securities  at  very  low  rates. 
On  May  25,  1917,  for  instance,  a  special  rate  of  from  two 
to  four  per  cent  was  established  at  the  New  York  Reserve 
Bank  for  member  banks'  one-day  collateral  notes  arising 
from  the  Government's  loan  operations.  This  was  raised 
to  three  to  four  and  one-half  per  cent  on  December  7,  1917." 

For  these  reasons  the  use  made  of  the  direct  collateral 
advance  was  great.  For  the  years  1917-20  inclusive  the 
amount  of  such  operations  was  as  follows:' 

'  Cf.  Report  of  the  Federal  Reserve  Hoard  for  1917,  p.  37. 
'  Fijjures  were  compiled  from  the  Report  of  the  Federal  Reserve  Board  for 
various  years. 


102 


FEDERAL  RESERVE  POLICY 


Year 

Member  Banks  Collateral  Notes 
Accepted  by  Reserve  Banks 

Total  Amount  of  Bills 
Discounted 

1917 

1918 

1919 

1920 

$  7,742,806,186 
33,007,788,230 
72,548,007,733 
55.565,447,000 

$  8,968,990,818 
39.752,933.847 
79,173.969,730 
85,320,874,000 

The  direct  collateral  loans  thus  came  to  constitute  by 
far  the  most  important  form  by  which  advances  were  made 
by  Federal  Reserve  banks  to  member  banks.  The  great 
bulk  of  these  loans  were  secured  by  United  States  certifi- 
cates of  indebtedness  and  Liberty  bonds.  This  is  indicated 
by  the  following  figures:^ 


Year 


1917 
I918 
1919 
1920 


Member  Banks  Collateral  Notes  Total  Amount    of    Direct    Col- 
Secured  BY  War  Paper  lateral  Loans  to  Member  Banks 


$  5,884,160,624 
32,142,405,711 
72,289,834,393 
55,410,876,000 


$  7,742,806,186 
33,007,788,230 
72,548,007,733 
55,565,447,000 


The  amount  of  reliance  placed  by  member  banks  upon 
the  direct  collateral  loan  after  the  fall  of  19 16  cannot  be 
stressed  too  highly.  In  the  first  place,  after  the  first  issue 
of  Government  war  securities  in  19 17,  we  hear  no  more 
about  the  inability  of  member  banks  to  take  advantage  of 
the  reserve  system's  rediscount  facilities  because  of  the 
lack  of  eligible  paper.  Practically  every  member  bank 
possessed  at  some  time  or  other  considerable  quantities  of 
war  paper.  This  sort  of  an  advance,  moreover,  rendered  it 
easy  for  the  Treasury  to  carry  out  its  easy-money  policy 
of  financing  the  war.  As  long  as  member  banks  could  re- 
discount their  own  notes  thus  collateraled  at  rates  approxi- 
mately equal  to  the  rates  borne  by  the  bonds,  and  as  long 

■  Figures  were  compiled  from  the  Report  of  the  Federal  Reserve  Board  for 
various  years. 


COLLATERAL  ADVANCES  TO  MEMBER  BANKS     103 

as  the  reserve  banks  continued  to  announce  their  policy 
of  cooperating  with  the  Treasury,  they  need  stand  in  no 
great  fear  of  over-subscribing  to  the  war  issues.  The  key 
to  the  ability  of  the  Treasury  to  float  billions  of  dollars 
of  bonds  at  a  low  interest  rate  lay  in  the  ability  of  mem- 
ber banks  to  obtain  funds  on  easy  terms  from  the  re- 
serve banks.  Permitting  the  notes  to  be  collatcraled  by 
Government  securities  virtually  offered  an  additional 
means  by  which  funds  could  be  obtained  from  the  Federal 
Reserve. 

Direct  advances  also  rendered  it  far  easier  for  the  banks 
to  carry  customers  who  employed  borrowed  funds  to  pur- 
chase the  war  bonds.  In  case  the  customer  should  not  com- 
plete his  payments  and  the  bond  should  revert  to  the  bank, 
the  bank  could  liquidate,  at  least  temporarily,  by  relying 
upon  the  reserve  bank.  In  large  measure  the  apparent  ease 
with  which  the  Treasury  obtained  a  market  for  its  issues 
can  be  attributed  to  this  amendment  of  September,  1916. 
In  opposite  fashion,  whatever  evils  resulted  from  the  easy- 
money  policy  of  war  finance  can  likewise  be  attributed 
largely  to  the  working  of  this  amendment. 

It  is  true  that  advances  of  this  sort  were  limited  to  bor- 
rowings of  fifteen  days'  duration.  Nevertheless,  the  Fed- 
eral Reserve  administration  was  very  liberal  in  its  renew- 
als. The  only  limitation  was  that  the  reserve  bank  must 
not  obligate  itself  to  make  such  renewal.^  Such  an  agree- 
ment might  create  the  situation  in  which  the  maturing 
note  would  be  paid  off  out  of  the  proceeds  of  the  new  dis- 
counts, and  the  fifteen-day  limitation  be  virtually  sus- 
pended. But  if  the  requirements  of  the  bank  should  be  due 
to  the  emergency  character  of  the  general  financial  situa- 
tion or  to  its  own  lil)eral  subscriptions,  there  was  little 
doubt  but  that  faith  could  be  reposed  in  the  ability  to 

•  See  Opinion  of  Counsel,  Law  Department,  Bulletin,  October  i,  1917,  p.  765. 


104  FEDERAL  RESERVE  POLICY 

obtain  such  renewals.     To  quote  from  the  Opinion  of 
Counsel  of  the  Board  :^ 

If,  however,  the  Federal  Reserve  Bank  is  under  no  such  agree- 
ment and  has  the  option  to  require  payment  in  cash,  it  may  at 
the  maturity  of  a  15-day  note  discount  another  for  the  same 
amount,  secured  by  the  same  or  substituted  collateral,  so  long 
as  the  two  transactions  are  independent  of  each  other. 

The  question  of  how  far  this  practice  should  be  encouraged 
by  Federal  Reserve  Banks  is  one  of  policy  rather  than  law.  It 
may  be  reasonably  assumed  that  the  Federal  Reserve  Banks 
will  not  permit  its  abuse. 

'  See  Opinion  of  Counsel,  Law  Department,  Bulletin,  October  i,  1917,  p.  765. 


CHAPTER  VI 
THE  DEVELOPMENT  OF  THE  TRADE  ACCEPTANCE 

In  the  earlier  days  of  reform-discussion  there  was  a  sharp 
difference  of  opinion  regarding  the  necessity  of  a  new  bank- 
ing structure.  On  the  one  hand,  it  was  argued  that  despite 
many  imperfections  of  detail  the  national  banking  system 
would  not  so  frequently  have  failed  to  function  adequately 
had  there  existed  in  this  country  a  strong  controlling 
bankers'  bank.  It  was  insisted  that  such  an  institution,  by 
compelling  credit-restraint  in  the  years  of  excessive  activ- 
ity, and  by  making  its  resources  easily  available  in  time  of 
emergency,  could  do  much  to  prevent  the  periodic  collapses 
of  the  credit  structure.  This  school  admitted  it  was  un- 
fortunate that  our  note  issues  were  based  upon  the  public 
debt;  that  our  reserves  for  bank  deposits  were  rigidly 
defined  at  law  and  improperly  employed  by  the  metropoli- 
tan financial  institutions;  that  the  peculiar  credit  needs  of 
foreign  trade  industries  had  been  so  largely  overlooked. 
Such  difficulties  as  these  were  admittedly  serious;  but, 
nevertheless,  it  was  insisted  that  a  central  bank  of  even 
moderate  resources  could  do  much  to  moderate  the  inten- 
sity of  our  credit  ills.  The  major  defect  was  held  to  be 
decentralization  in  reserve  holdings,  in  note  issues,  and  in 
control. 

A  second  school,  however,  endeavored  to  formulate  the 
tenet  that  no  new  banking  structure  was  required  or  was 
even  desirable.  In  view  of  the  prevailing  hostility  to  the 
idea  of  a  central  bank,  it  would  be  futile  politically  to 


io6  FEDERAL  RESERVE  POLICY 

endeavor  to  devise  a  dominating  bankers'  bank.  Rather, 
reform  measures  should  proceed  on  less  ambitious  lines. 
Instead  of  retaining  rigid  reserve  requirements  for  depos- 
its, we  should  provide  for  elasticity  by  the  employment  of 
a  graduated  tax  on  deficient  reserves;  note  issues  should  be 
based  on  the  general  commercial  assets  of  a  bank  rather 
than  upon  its  holdings  of  Government  bonds;  foreign 
trade  difficulties  should  be  corrected  by  bestowing  addi- 
tional powers  upon  national  banks  such  as  the  right  to 
accept  bills  and  drafts  for  international  commerce  pur- 
poses. Finally,  as  a  matter  of  very  great  importance,  many 
improvements  could  be  wrought  in  our  commercial  paper 
and  trade  credit  usages.  In  particular,  the  attempt  could 
be  made  to  increase  the  use  in  commercial  transactions  of 
two-name  trade  paper. 

As  the  controversy  progressed,  however,  these  two 
schools  of  thought  became  less  sharply  differentiated.  On 
the  one  hand,  it  came  to  be  more  widely  perceived  that  a 
central  bank  might  encounter  serious  difficulties  unless 
reserve  requirements  were  rendered  less  rigid ;  note  issues 
less  inelastic;  commercial  paper  less  unsound.  On  the 
other  hand,  it  was  gradually  recognized  that  the  adminis- 
trative.  development  of  many  proposed  reforms  would 
require  the  sponsorship  of  a  large  dominating  central 
institution.  In  particular  a  more  liquid  type  of  commer- 
cial paper  could  be  popularized  only  by  a  propaganda 
more  effective  than  any  private  agencies  without  power  to 
act  could  conduct.  Was  not  this  the  teaching  of  past  finan- 
cial history?  Despite  the  admitted  evils  of  earlier  trade 
credit  methods,  the  privately  controlled  banks  had  failed 
to  develop  a  wide  open  market  for  sound  commercial 
paper.  The  only  hope  of  improvement  lay  In  the  forma- 
tion of  a  strong  central  Institution  with  power  to  guide  and 
influence. 


DEVELOPMENT  OF  TRADE  ACCEPTANCE  107 

Viewed  in  this  light,  the  campaign  for  double-name 
commercial  paper  becomes  one  of  the  most  prominent 
aspects  of  the  reform  begun  in  19 14.  The  Federal  Reserve 
banks  were  not  to  be  solely  discount  institutions;  they 
also  were  to  be  the  sponsors  and  the  leaders  in  the  propa- 
ganda for  more  sound  methods  of  commercial  banking. 
In  this  respect  was  realized  the  special  contribution  of  a 
man  who  played  a  peculiarly  important  role  in  banking 
progress.  Prior  to  19 13  Paul  M.  Warburg  was  closely 
identified  with  credit-reform,  and  after  the  passage  of  the 
Owen-Glass  Bill  he  was  a  member  of  the  first  Federal 
Reserve  Board.  The  life  of  his  work  survived  many 
changes  of  political  and  legislative  control.  During  the 
period  of  preparation  of  the  Aid  rich  Bill,  his  contribution 
to  the  publications  of  the  National  Monetary  Commission 
was  The  Discount  System  in  Europe.  In  this  work  the  main 
contrast  between  European  and  American  banking  meth- 
ods was  asserted  to  be  no  more  the  lack  of  a  central  bank 
here  than  that 

The  European  financial  system  is  constructed  upon  discounts 
as  its  foundation;  the  American  system  is  constructed  upon 
stocks  and  bonds  as  its  foundation. ' 

The  especial  virtue  of  the  European  credit  mechanism  was 
that  its  "discount  system  mobilizes  the  resources  of  the 
banks."'   Further: 

The  discount  and  central  bank  system  enables  the  Nation  to 
meet  these  situations  by  concerted  but  varying  action  adjusted 
to  meet  each  individual  case.^ 

The  historical  causes  of  present  methods  of  trade  credit 

are  now  generally  understood.   Prior  to  the  Civil  War  the 

bill  of  exchange,  drawn  by  the  seller  against  the  bu}er,  was 

'  Page  23. 
'  Page  39 
5  Page  37.   Italics  arc  the  writer's. 


io8  FEDERAL  RESERVE  POLICY 

commonly  employed.  The  bill,  when  accepted,  would  be 
discounted  at  the  seller's  bank.  In  this  way  the  seller 
rendered  liquid  his  trade  assets;  the  seller's  bank  commonly 
had  available  a  supply  of  easily  negotiable  commercial 
paper;  and  the  buyer  endeavored  to  conduct  his  opera- 
tions in  such  a  way  as  to  ensure  his  ability  to  meet  his 
obligations  on  the  promised  date. 

Gradually,  however,  this  custom  was  superseded  by  the 
open  book  account  system  coupled  with  the  offer  of  a  lib- 
eral discount  for  prompt  cash  payment.  This  change  in 
methods  is  explained  by  the  writers  as  due  largely  to  two 
causes.'  First,  the  fluctuating  value  of  the  dollar  in  the 
greenback  days  rendered  tradesmen  anxious  to  close  their 
accounts  as  soon  as  possible.  Many  of  them  began  to  offer 
large  discounts  to  ensure  early  payments.  Since  it  would 
not  do  to  obligate  the  buyer  to  pay  on  a  future  date,  his 
indebtedness  would  be  carried  currently  as  a  book  account. 
In  this  way,  two-name  trade  paper  became  less  and  less 
common.  To  acquire  the  funds  for  his  remittance  the 
buyer  would  offer  his  banker  his  own  single-name  note. 
Control  over  trade  credit  has  passed  more  and  more  from 
the  hands  of  the  wholesaler's  bank  and  has  been  lodged  in 
the  hands  of  the  local  banker.  If  the  buyer  did  not  remit 
promptly,  the  seller  might  be  obliged  to  obtain  a  line  of 
bank  credit.  But  the  paper  of  the  seller  was  his  own  single- 
name,  and  did  not  evidence  any  particular  transaction. 

We  are  also  informed,  as  a  second  explanation  of  the 
change  in  trade  credit  methods,  of  the  development  of  the 
work  of  the  traveling  salesman  in  such  a  way  as  to  alter 
the  legal  position  of  the  buyer.  When  the  retailer  selected 
from  the  stock  of  the  wholesaler  as  in  the  earlier  days  and 
had  an  opportunity  to  examine  the  quality  of  the  goods, 

'  Cf.,  for  instance,  E.  E.  Agger,  "The  Conxmercial  Paper  Debate,"  Journal  of 
Political  Economy,  July,  19 14,  pp.  663-67 


DEVELOPMENT  OF  TRADE  ACCEPTANCE  109 

the  legal  doctrine  of  caveat  emptor  prevailed.  But  when 
he  bought  from  sample,  he  had  a  right  to  insist  that  the 
goods  conform  to  the  quality  of  the  sample.  Before  ac- 
knowledging his  indebtedness  he  must  have  an  opportu- 
nity to  inspect  the  goods.  He  prefers  to  be  carried  on  the 
books  in  the  meanwhile  and  consequently  objects  to 
accepting  immediately  a  draft. 

But  despite  these  facts  it  seems  difficult  to  account  for 
the  extremely  great  scarcity  of  good  two-name  trade  paper 
in  1 9 14.  It  would  seem  as  if  the  demand  on  the  part  of  the 
bank  with  surplus  funds  to  invest  would  have  created  at 
least  a  limited  field  for  this  type  of  paper.  It  would  seem 
reckless  to  assert  that  the  requirements  of  the  capitalist 
were  absolutely  impotent. 

Answers  to  this  query  may  be  had,  however,  by  noting 
the  type  of  transactions  to  which  paper  similar  in  form  to 
the  bill  of  exchange  was  customarily  employed.  The  draft 
had  been  relegated  in  trade  transactions  largely  to  the 
slow  accounts.  It  was  employed  in  many  cases  because 
the  seller  had  become  so  suspicious  regarding  the  buyer's 
ability  to  pay  or  so  impatient  at  his  delay  that  he  demands 
a  definite  acknowledgment  of  the  buyer's  obligation  to 
remit  on  a  definite  date.  Two-name  commercial  paper  was 
in  bad  company. 

Some  difficulty,  moreover,  was  experienced  frequently 
in  the  collection  of  two-name  paper.  The  drafts  were 
usually  not  made  payable  at  any  bank  specified  by  the 
buyer  of  the  goods.  In  this  respect  its  position  differs 
somewhat  from  that  of  the  modern  trade  acceptance.  Under 
the  Negotiable  Instruments  Law,  recognized  in  a  large 
majority  of  our  States,  a  trade  acceptance  made  payable 
at  a  specified  bank  operates  in  the  same  manner  as  a  check. 
Upon  maturity,  if  presented  for  payment,  it  will  be  charged 
to  the  account  of  the  buyer  provided  there  are  sufticient 
funds  to  meet  it. 


no  FEDERAL  RESERVE  POLICY 

Banking  facts,  also,  help  to  explain  our  inability  to 
develop  good  two-name  trade  paper.  For  various  reasons 
there  existed  no  broad  open  market,  upon  which  the  bank 
could  depend  confidently  for  the  sale  of  its  short-time 
commercial  paper.  With  a  strong  central  bank  in  exist- 
ence, directed  from  the  standpoint  of  public  needs,  there 
should  not  have  been  the  same  difficulty  in  time  of  emer- 
gency of  liquidating  upon  holdings  of  such  paper.  Since 
the  time  of  Andrew  Jackson,  however,  no  such  institution 
had  existed  in  this  country.  It  seemed  preferable,  there- 
fore, in  establishing  a  secondary  reserve  to  invest  in  securi- 
ties for  which  the  stock  exchanges  furnished  continuous 
quotations.  This  was  the  basis  of  Warburg's  remark,  pre- 
viously quoted,^  that  "the  American  system  is  constructed 
upon  stocks  and  bonds  as  its  foundation." 

Finally,  unlike  the  currency  systems  of  most  continental 
European  countries,  our  banking  law  placed  no  premium 
on  commercial  paper  as  a  basis  for  note  issues.  The  bond- 
secured  note  issue  has  much  for  which  to  answer. 

If,  then,  it  was  generally  agreed  in  19 13  that  the  Federal 
Reserve  must  assume  a  large  measure  of  responsibility  for 
the  development  of  an  improved  type  of  trade  paper,  what 
were  the  pertinent  provisions  of  the  original  statute?  It 
has  been  stated  previously  that,  while  the  matter  was  con- 
sidered seriously,  the  lawmakers  refused  to  designate  two- 
name  trade  paper  as  the  sole  type  eligible  for  rediscount. 
By  the  terms  of  section  13,  reserve  banks  were  given  the 
right  to  discount  any  of  the  following:  "notes,  drafts,  and 
bills  of  exchange  arising  out  of  actual  commercial  trans- 
actions."  Eligible  paper  was  to  depend,  therefore,  upon 
the  nature  of  the  underlying  transaction  and  not  upon  the 
form  of  the  paper.  The  concessions  of  this  section  (number 
13)  are  confined  to  certain  permissions  for  the  rediscount 

'  See  supra,  p.  107. 


DEVELOPMENT  OF  TRADE  ACCEPTANCE  in 

of  a  larger  amount  of  paper  bearing  the  signature  of  one 
party  than  in  the  case  other  types  of  paper  are  offered. 
This  matter  will  be  discussed  briefly  toward  the  close  of  the 
chapter. 

It  is  in  the  open-market  section  (number  14)  that  we 
fmd  the  principal  concession  to  trade  paper.  Rescrv^e 
banks  are  empowered  to  purchase  "from  member  banks 
and  to  sell,  with  or  without  its  indorsement,  bills  of 
exchange  arising  out  of  commercial  transactions."  This 
constitutes  an  evident  discrimination  in  favor  of  two-name 
trade  paper,  since  nowhere  is  the  promissory  note  included 
in  the  permissible  class  of  open-market  investments.  De- 
spite these  concessions,  however,  statutory  recognition  of 
two-name  trade  paper  is  so  limited  that  its  later  develop- 
ment must  be  credited  largely  to  the  discretionary  acts  of 
the  reserve  administration. 

Before  investigating  the  trade  paper  policy  of  the  reserve 
administration,  it  may  be  desirable  to  recall  some  of  the 
advantages  urged  in  behalf  of  encouraging  the  use  of  a 
proper  type  of  the  commercial  bill  of  exchange.  These 
supposed  advantages  have  been  heralded  so  widely  and 
discussed  so  generally  that  we  shall  attempt  to  do  no  more 
here  than  to  mention  them  briefly.  These  advantages  may 
be  classified  as  falling  under  three  heads:  first,  those  of 
special  concern  to  the  seller  of  the  goods;  second,  those 
addressed  primarily  to  the  buyer;  and,  lastly,  those  ap- 
pealing most  directly  to  the  self-interest  of  the  banker. 

To  the  seller  the  arguments  were  based  on  the  oppor- 
tunity of  securing  almost  immediately  upon  the  sale  of  the 
goods  a  definite  agreement  of  the  buyer  to  pay  on  a  certain 
date,  an  agreement,  moreover,  which  is  couched  in  nego- 
tiable form.  Much  preferable,  therefore,  is  it  to  the  uncer- 
tain and  unadmitted  obligation  of  the  buyer  as  evidenced 
only  by  the  seller's  book  records.   Bad  debts  and  slow  i^iy- 


112  FEDERAL  RESERVE  POLICY 

mcnts  must  be  lessened  by  the  encouragement  of  such 
paper.  If  payments  of  the  purchaser  are  speeded  up,  the 
bank  borrowings  of  the  seller  need  not  be  nearly  so  great ; 
and  the  cost  of  securing  working  capital  is  reduced,  a  fac- 
tor, moreover,  which  competition  must  gradually  cause  to 
redound  to  the  benefit  of  the  public.  But  even  if  no  speed- 
ing up  of  payments  is  induced,  trade  paper  may  still  per- 
mit the  seller  to  liquidate  his  assets  more  quickly.  The 
book  accounts  of  the  seller,  ordinarily,  were  difficult  to 
assign.  Requests  for  borrowed  funds  on  the  basis  of  such 
assigned  accounts  were  interpreted  frequently  as  evidence 
of  the  faulty  financial  position  of  the  seller.  Because  such 
assignments  were  in  general  disuse,  such  requests  were 
frequently  interpreted  as  evidence  of  the  impaired  finan- 
cial standing  of  the  applicant.  The  accepted  draft  of  the 
buyer,  drawn  at  the  time  of  shipment,  should  prove  much 
more  negotiable,  and  therefore  enable  the  local  banker  to 
make  advances  even  though  his  own  ability  to  continue  to 
hold  the  acceptance  is  doubtful.  In  other  words,  the  wider 
the  market  for  commercial  paper,  the  greater  the  ability 
to  liquidate  trade  assets  quickly. 

It  has  proved  somewhat  more  difficult  to  convince  the 
buyer  of  the  advantages  to  be  derived  by  the  substitution 
of  trade  paper  for  the  open  account.  It  is  true  that  it  was 
easy  to  argue  that  any  system  which  would  render  more 
certain  to  the  seller  the  redeemability  of  his  payments  re- 
ceivable must  gradually  through  the  force  of  competition 
lessen  the  charges  exacted  by  the  seller.  But  would  it  secure 
immediately,  in  the  specific  transaction  in  hand,  and  with 
relation  to  his  own  competitors,  any  cheaper  terms?  It 
must  be  borne  in  mind  that  the  average  buyer  makes  one 
transaction  at  a  time  and  is  only  indirectly  interested  in 
improving  methods  employed  by  trade  as  a  whole.  Too 
often  the  propaganda  has  confused  general  and  long-time 


DEVELOPMENT  OF  TRADE  ACCEPTANCE  113 

advantages  with  those  of  special  and  immediate  interest 
to  the  buying  business  man.  It  may  be  true  also  that  the 
trade  acceptance  method  may  serve  to  check  reckless  buy- 
ing on  the  part  of  the  purchaser.  But  must  it  not  be 
difficult  to  convince  any  one  purchaser  that  his  buying 
habits  are  so  loose  as  to  necessitate  his  obligating  himself 
to  make  payment  on  a  specific,  definite  date?  Clearly, 
arguments  to  the  purchaser  have  greater  force  when  the 
appeal  is  based  upon  specific  individual  advantages  in  the 
particular  transaction  in  which  his  acceptance  is  requested. 

Arguments  of  immediate  individual  advantage  might 
be  the  following:  In  the  first  place,  the  buyer  who  agrees 
to  obligate  himself  definitely  regarding  the  time  of  pay- 
ment improves  his  credit  position  with  his  banker.  Often  a 
query  of  the  banker  is  this  —  do  you  accept  trade  drafts? 
An  affirmative  answer  may  raise  the  buyer's  credit  rating.* 
It  is  to  be  admitted,  of  course,  that  the  underlying  expla- 
nation of  this  discrimination  is  to  some  extent  artificial. 
The  motive  of  the  member  banks  in  encouraging  the 
acceptance  frequently  has  been  their  desire  to  secure  a 
type  of  paper  rediscountable  with  the  Federal  Reserve  at 
a  low,  preferential  rate.  But  whatever  the  source  of  dis- 
crimination, it  has  been  made  to  apply  with  increasing 
force.  In  some  industries,  firms  which  accept  trade  drafts 
have  been  able  to  insist  upon  better  terms  as  regards  cost 
of  goods  and  quantity  obtainable.  These  firms  could 
advance  the  argument  that  theacceptance  enables  the  seller 
to  obtain  his  bank  credit  at  a  cheaper  rate.  Frequently 
also  the  acceptance  offered  a  means  by  which  the  small 
and  comparatively  unknown  firms  were  able  to  place 
themselves  more  largely  upon  a  position  of  credit  equality 
with  those  of  a  more  firmly  established  credit  standing. 

The  advantages  of  trade  paper  could  also  be  heralded  to 

'Certain  exceptions  to  this  statement  will  be  discussed  later  in  this  chapter. 


114  FEDERAL  RESERVE  POLICY 

the  commercial  banker.  It  has  been  remarked  that  in  the 
past  it  was  customary  in  the  slack  seasons  for  the  interior 
banks  to  invest  in  large  volume  surplus  funds  in  the  secur- 
ity market  or  to  place  them  on  deposit  with  their  corre- 
spondents in  the  financial  centers.  In  recent  years  the  work 
of  the  note  broker  had  so  developed  that  it  was  compara- 
tively easy  to  find  an  outside  market  for  these  surplus 
funds  by  investments  in  short-time  commercial  paper. 
But  the  ability  in  an  emergency  to  liquidate  such  paper  in 
advance  of  the  date  of  maturity  was  a  factor  of  doubt. 
Commercial  paper  investments,  sufficiently  attractive  so 
far  as  yield  was  concerned,  did  not  make  a  good  secondary 
reserve.  The  limited  open  market  for  such  paper  explains, 
therefore,  in  large  measure  the  huge  volume  of  commercial 
bank  funds  regularly  invested  in  the  bond  market  or  rede- 
posited  with  the  financial  institutions  in  the  stock  market 
centers  which  bid  for  such  funds. 

The  danger  of  these  practices  was  called  to  the  public's 
attention  forcibly  in  the  panic  of  1907.  The  call  of  the  inte- 
rior banks  for  New  York  funds  and  the  general  attempt 
to  liquidate  quickly  on  security  investments  soon  caused 
a  general  suspension  of  payments  in  our  financial  center. 

But  correction  of  this  difficulty  was  not  easy.  Crisis 
and  financial  panics  are  not  ordinarily  contemplated  as  of 
inevitable  recurrence.  A  change  from  old  methods  could 
be  induced  only  by  establishing  in  normal  times  a  wide 
open  market  for  commercial  paper.  The  market  should  be 
so  broad  and  steady  as  to  offer  the  same  means  of  liquidat- 
ing assets  as  those  furnished  by  bank  redeposits  and  bond 
investments.  Here  was  the  place  for  the  trade  acceptance. 
It  was  two-name,  had  its  origin  presumably  in  an  automat- 
ically liquidating  commercial  operation,  and  with  proper 
backing  from  reserve  authorities  could  be  converted  into 
cash  on  occasions  of  real  need. 


DEVELOPMENT  OF  TRADE  ACCEPTANCE  115 

It  was  accordingly  possible  to  make  for  the  acceptance 
an  appeal  to  all  classes  of  the  business  public.  As  to  the 
means  which  must  necessarily  be  employed  to  increase  its 
use,  it  has  been  stated  previously  that  these  depended 
largely  upon  the  discretionary  power  of  the  reserve  admin- 
istration. It  was  not  a  matter  of  slavish  devotion  to  the 
terms  of  the  statute.  Favorable  discrimination  was  con- 
fined by  the  act  to  the  provisions  relating  to  open-market 
operations  and  to  those  bearing  upon  the  amount  of  redis- 
countable  paper  bearing  the  signature  of  any  one  party. 
It  is  therefore  necessary  to  inquire  next  as  to  the  precise 
means  employed  by  the  reserve  management  to  extend 
the  use  of  such  paper. 

In  circulars  issued  November  16,  1914,  and  April  2, 
1915,  the  F^ederal  Reserv^e  Board  outlined  certain  special 
privileges  and  preferential  rates  of  discount  to  be  enjoyed 
by  the  acceptance.  But  the  trade  acceptance  as  a  distinct 
class  of  commercial  paper  dates  its  origin  to  the  issuance  of 
Regulation  J,  Series  of  1915.  By  this  regulation  the  name, 
"trade  acceptance,"  is  devised  for  double-name  commer- 
cial paper  which  conforms  to  certain  requirements.  The 
intention  was  to  find  a  means  of  distinguishing  this  new 
type  of  commercial  paper  from  other  paper,  similar  in 
form,  but  lacking  some  of  its  essential  characteristics.  For 
instance,  the  trade  acceptance  would  be  similar  in  form  to 
a  draft  arising  from  other  sorts  of  transactions  than  those 
purely  commercial.  To  deserve  the  title  of  "  trade  accept- 
ance" and  to  enjoy  the  special  privileges  which  it  was 
proposed  to  grant  it,  the  paper  must  conform  to  the  follow- 
ing qualifications:  First,  it  must  be  drawn  by  the  seller  of 
the  goods  against  the  buyer.  Second,  it  must  be  drawn  on 
account  of  the  indebtedness  created  by  the  transfer  of  the 
goods  and  for  no  other  reason.  Third,  it  must  be  accepted 
by  the  buyer  under  conditions  whereby  the  date  of  pay- 


Ii6  FEDERAL  RESERVE  POLICY 

ment  is  made  certain.  When  presented  to  a  reserve  bank 
for  discount,  such  paper  must  bear  the  endorsement  of  a 
member  bank,  and  must  have  a  maturity  at  time  of  redis- 
count of  not  more  than  ninety  days.  Evidence  of  the 
nature  of  the  underlying  transaction  could  consist  of  a  cer- 
tificate to  the  effect  that  "The  obligation  of  the  acceptor 
of  this  bill  arises  out  of  the  purchase  of  goods  from  the 
drawer."  If  it  so  desired,  the  district  directorate  could 
inquire  into  the  exact  nature  of  the  basic  operation. 

A  perusal  of  the  terms  of  this  regulation  will  suggest  the 
answer  to  the  query  as  to  why  this  favored  class  of  paper 
must  be  made  out  solely  in  the  form  of  the  draft.  Would 
not  a  promissory  note  for  the  amount  of  the  goods  ten- 
dered to  the  seller  by  the  purchaser  possess  the  virtues 
desired  for  the  trade  acceptance,  namely,  that  the  paper 
be  double-name  and  that  it  arise  out  of  an  operation  of 
commerce?  Discrimination  in  favor  of  the  draft  depended, 
not  on  belief  that  the  form  of  the  paper  proves  the  nature 
of  the  operation,  but  upon  the  belief  that  a  trade  transac- 
tion can  ordinarily  be  proved  more  readily  when  the  paper 
is  in  the  form  of  a  draft.  In  case  of  the  draft  the  seller  and 
not  the  buyer  takes  the  initiative  in  making  out  the  trans- 
action. The  buyer  may  postpone  so  long  the  making  out 
of  the  note  that  it  might  be  difficult  to  determine  which  of 
a  series  of  operations  was  financed  by  any  one  piece  of 
paper.  The  draft  lends  itself  readily  to  the  requirement 
that  proof  of  the  transaction  be  available  at  the  time  the 
paper  is  presented  to  the  banker.  If  desired,  the  bank  can 
insist  that  the  bill  of  lading  and  other  shipping  documents 
be  attached  to  the  note  which  is  offered  for  discount. 

What  success  has  been  realized  in  the  endeavor  to  popu- 
larize such  paper?  Complete  and  accurate  information 
regarding  this  matter  is  difficult  or  impossible  to  obtain. 
Some  indication  of  the  use  of  this  paper  may  be  had  by 


DEVELOPMENT  OF  TRADE  ACCEPTANCE  117 

examining  the  discount  operations  of  the  reserve  banks  in 
such  a  way  as  to  compare  the  amount  of  trade  acceptances 
discounted  to  commercial  paper  of  all  classes.  Figures  are 
not  given  for  open-market  operations,  since  the  volume  of 
these  reflects  too  greatly  the  volition  of  the  reserve  man- 
agement. What  we  need  to  obtain  is  information  indica- 
tive of  the  holdings  of  member  banks.* 


Trade  Acceptances  Dis- 

Total of  all  Classes 

Percentage  of  Trade 

Year 

counted  FOR  Member 

of  Discounted  Paper 

Acceptances  to  all 

Banks 

Classes   of   Dis- 

In  Thousand* 

3  of  Dollars 

1920  .  . 

$192,157 

$85,320,874 

.2 

1919.. 

138,420 

79.173.970 

.1 

1918.. 

. .;     187-373     ^  . 

39.752,934 

•4 

1917.. 

37.771 

8,968,990 

•4 

I916  .  . 

5-212 

207,870 

2.5 

These  figures  do  not  indicate  any  such  startling  growth 
in  the  use  of  trade  acceptances  as  to  suggest  a  sudden  and 
complete  revolution  in  trade  credit  methods.  Of  course 
the  nature  of  reserve  bank  operations  does  not  portray 
with  exactness  the  condition  of  member  bank  portfolios. 
But  the  larger  the  amount  of  acceptances  held  by  member 
banks,  the  greater  the  probability  that  the  proportion  of 
this  paper  discounted  to  that  of  other  classes  will  be  large, 
and  vice  versa.  But  in  one  way  these  figures  may  not  do 
exact  justice  to  the  acceptance.  In  the  earlier  years  of 
reserve  operations  the  trade  acceptance  was  discountable 
at  a  lower  rate  than  other  classes  of  paper.  Later  this 
preference  was  eliminated.  At  no  time,  however,  was 
there  a  rate  discrimination  against  the  trade  acceptance. 
And  the  general  conclusion  derived  by  examining  the  fig- 
ures is  confirmed  by  the  prevailing  type  of  literature  upon 
the  subject.  A  very  large  portion  of  it  attempts  to  explain 

'  Figures  are  obtained  from  the  Annual  Reports  of  tiic  Federal  Reserve  Board. 


ii8  FEDERAL  RESERVE  POLICY 

the  nature  of  the  difficulties  encountered  in  the  endeavor 
to  secure  its  popularization.  Let  us  next,  therefore,  at- 
tempt to  state  some  of  the  obstacles  which  stood  in  the  way 
of  a  wide  extension  of  its  use. 

A  first  difficulty  was  the  easily  explained  hostility  of 
many  of  the  stronger  firms  in  various  industries.  Many 
such  hesitated  to  encourage  the  use  of  a  new  instrument 
which  tends  to  place  their  smaller  rivals  on  a  position  of 
credit  equality.   In  Warburg's  words :  * 

When  borrowing  on  Its  own  note,  the  strong  firm,  with  well- 
established  credit,  can  obtain  larger  loans  and  on  more  favor- 
able terms  than  its  small  competitor,  and  it  is,  therefore,  in 
position  to  finance  Its  purchases  and  its  sales  on  a  more  favor- 
able basis  than  the  small  firm.  It  gains  the  advantage  both  as 
to  the  larger  scope  of  business  It  can  do  and  the  lower  interest 
rate  it  enjoys.  True,  it  could  probably  do  a  larger  business  than 
at  present  by  adopting  the  trade  acceptance  plan,  but  by  thus 
adopting  the  trade  acceptance  basis  small  firms  would  probably 
profit  more  in  proportion  than  the  larger  ones;  their  handicap 
would  be  lightened. 

It  is  necessarily  more  difficult  to  secure  an  inroad  for 
the  acceptance  by  appealing  to  the  smaller  establishments. 
Their  customs  and  methods  are  not  studied  so  thoroughly 
by  the  trade  as  are  those  of  their  larger  rivals.  The  lead 
must  be  taken  by  the  leaders.  And  it  could  not  be  expected 
that  weaker  establishments,  those  with  a  very  low  credit 
rating,  could  be  led  easily  to,  seize  the  opportunity  of 
removing  their  credit  disadvantage  by  adopting  the  accept- 
ance. These  weak  firms  object  to  binding  themselves  to 
pay  on  a  definite  date.  Moreover,  there  has  been  no  desire 
on  the  part  of  the  acceptance  propagandists  to  make  this 
type  of  paper  the  resort  of  the  weak  firm.  No  paper  can 
classify  more  highly  than  the  standing  of  the  obligee. 
Much  difficulty  has  also  been  experienced  in  converting 
•  From  address  published  in  part  in  BuUelin,  July,  1918,  p.  605. 


DEVELOPMENT  OF  TRADE  ACCEPTANCE  119 

the  commercial  banker  to  the  new  method.    To  quote 
Warburg  again :  ^ 

Some  bankers  assert  that  in  buying  a  promissory  note  the 
mere  fact  that  they  are  conscious  of  buying  the  naked  note 
of  a  customer  furnishes  a  reason  for  their  feeling  obliged  to 
carefully  analyze  the  statement  of  the  customer  and  to  judge 
the  merit  of  the  borrower  upon  the  statement  of  the  iatter's 
financial  condition.  They  allege  that  this  practice  is  safer  than 
that  of  purchasing  a  trade  acceptance  issued  by  the  same  firm, 
because,  as  they  say,  in  that  case  they  are  likely  to  rely  on  the 
legitimate  character  of  this  double-name  paper  without  examin- 
ing as  cautiously  as  they  otherwise  would  the  general  condition 
of  the  borrower. 

The  answer  to  this  view  has  been  stated  previously. 
Bankers  who  purchase  acceptances  should  examine  the 
financial  condition  of  the  parties  as  carefully  as  when  dis- 
counting a  single-name  promissory  note.  It  never  was 
contemplated  that  a  change  in  the  form  of  paper  would 
eliminate  the  necessity  of  such  examination.  Such  a  result 
would  be  an  unfortunate  by-product  of  the  trade  accept- 
ance movement. 

Some  firms  which  employ  the  trade  acceptance  are 
obliged  frequently  to  borrow  on  their  own  single-name 
note.  A  question  which  confronts  the  banker  In  such  situa- 
tions is  whether  the  use  of  the  acceptance  in  other  trans- 
actions impairs  the  quality  of  this  paper.  Some  bankers 
have  answered  this  question  in  the  affirmative  by  announc- 
ing their  reluctance  to  buy  the  single-name  paper  of  a 
borrower  who  practices  the  sale  of  his  trade  acceptances.' 

The  reason  given  for  this  view  is  that  whoever  buys  a  trade 
acceptance  acquires  the  first  lien  on  what  would  otherwise  have 
represented  one  of  the  accounts  receivable  of  the  concern  which 
drew  the  acceptance,  and  in  addition  to  that  lien,  in  case  of 

'  From  address  publislicd  in  part  in  Bulletin,  July,  1918,  p.  604. 
'Ibid. 


120  FEDERAL  RESERVE  POLICY 

bankruptcy  of  the  drawer  of  the  acceptance,  the  holder  of 
that  acceptance  would  rank  equally  with  the  unsecured  note 
holder  as  a  general  creditor  for  any  part  of  the  acceptance  which 
the  acceptor  might  not  have  paid. 

The  answer  to  this  contention  has  already  been  indi- 
cated. Examination  and  financial  analysis  are  as  necessary 
as  in  the  case  of  the  unsupported  single-name  note.  With 
proper  care  this  objection  should  not  hold.  Unless  its 
privileges  are  abused,  the  practice  of  accepting  should 
improve  the  borrower's  credit  rating.  It  implies  a  willing- 
ness to  meet  obligations  on  a  definite  date  and  a  desire  to 
avoid  buying  in  excess  of  ability  to  pay. 

All  in  all  it  appears  that  the  reserve  management  has 
been  amply  justified  in  lending  its  aid  to  the  trade  accept- 
ance movement.  But  the  moment  special  privileges  are 
granted,  new  difficulties  arise.  Inevitably  attempts  are 
made  to  create  a  paper,  similar  in  form  to  the  trade  accept- 
ance, but  for  purposes  not  contemplated  by  the  reserve 
administration.  Unless  such  attempts  are  checked,  the 
distinctive  place  of  the  trade  acceptance  as  an  easily 
liquidated  type  of  commercial  paper  is  lost. 

One  of  these  objectionable  methods  has  been  to  employ 
it  in  old  accounts.  Because  of  the  greater  proportion  of 
bad  debts,  in  such  cases  it  would  not  have  been  surprising 
had  the  Board  ruled  that  the  draft  thus  drawn  did  not  con- 
form to  its  conception  of  the  trade  acceptance.  The  Board 
might  have  ruled  that  the  draft  must  be  drawn  only  at  the 
time  of  the  transfer  of  the  goods.  But  in  this  matter  the 
Board's  ruling  was  liberal.  In  an  Informal  Ruling  we  read :  * 

A  bill  drawn  by  a  retail  dealer  on  his  retail  customer  to  finance 
the  sale  of  goods  to  that  customer  is  a  trade  acceptance  within 
the  meaning  of  the  Board's  regulations,  even  though  it  is  drawn 
after  the  purchaser  has  failed  to  remit  promptly  on  an  open 
account. 

'  Bulletin,  January,  191 8,  p.  30. 


DEVELOPMENT  OF  TRADE  ACCEPTANCE     121 

But  even  though  such  drafts  might  be  held  technically 
admissible,  it  is  suggested,  as  a  matter  of  not  subordinating 
"the  trade  acceptance  to  the  open  account  by  suggesting 
it  as  a  last  resort  for  bad  debts,"  that  reserve  banks 
"should  be  encouraged  to  discriminate  against  them  as  far 
as  possible.  ..." 

In  the  minds  of  some,  doubt  existed  as  to  the  status  of 
the  trade  draft  on  occasions  when  the  purpose  of  the  buyer 
was  not  to  resell  the  goods,  but  to  use  them  for  some  other 
purpose.  The  argument  against  the  admission  of  these 
drafts  would  be  that  such  use  destroys  their  character  as 
paper  automatically  redeemed  out  of  the  sale  of  the  goods. 
Aside,  however,  from  the  difficulty  of  ascertaining  the 
facts  in  each  case,  such  a  limitation  might  confine  the 
acceptance  too  largely  to  the  field  of  distribution  and  ren- 
der it  more  difficult  for  the  manufacturer  and  producer  to 
derive  advantage  through  the  development  of  this  new 
type  of  trade  paper.  On  strictly  logical  grounds,  moreover, 
it  might  not  make  so  much  difference  whether  the  goods 
were  to  be  resold.  They  might  be  used  in  such  a  way  as  to 
aid  the  purchaser  in  the  sale  of  other  goods.  They  might 
assist  in  increasing  the  liquidation  of  other  goods. 

But  the  basic  transaction  must  be  real  and  not  ficti- 
tious. Various  subterfuges  are  attempted  frequently  to 
enable  the  drawing  of  the  drafts,  which  are  then  paraded 
as  bona  fide  acceptances.  One  of  the  more  common  of 
these  devices  is  the  formation  of  subsidiary  sales  corpora- 
tions which  act  as  the  acceptors  of  the  drafts.  In  reality 
the  transaction  may  not  involve  even  the  transfer  of  goods 
from  one  department  of  the  business  to  another.  Such 
bills  come  close  to  classifying  as  those  in  which  the  drawer 
makes  out  the  draft  against  himself. 

In  another  connection  the  status  of  a  bill,  which  in  effect 
was  drawn  by  the  drawer  against  himself,  was  stated  in  an 


122  FEDERAL  RESERVE  POLICY 

opinion  of  M.  C.  Elliott,  then  Counsel  of  the  Federal 
Reserve  Board:*  "In  substance  such  an  instrument  is  a 
promissory  note,  single-name  paper  and  no  more."  But 
subsidiary  corporations,  subsidiary  though  they  be,  pos- 
sess an  independent  corporate  life.  Would,  then,  a  "draft 
drawn  by  a  lumber  corporation  upon  a  sales  corporation 
which  it  and  a  number  of  other  lumber  concerns  have 
organized  .  .  .  when  accepted,  become  a  trade  accept- 
ance, even  though  the  selling  corporation  is  a  stockholder 
of  the  sales  corporation "?' 

The  opinion  of  counsel  in  this  case  was  couched  in  very 
general  terms.  The  status  of  the  paper  would  depend  upon 
the  purpose  underlying  the  existence  of  the  sales  corpora- 
tion. Such  paper  could  be  classified  as  trade  acceptance 
paper  if  the  sales  corporation  was  organized  in  good  faith 
and  not  merely  as  an  agent  of  the  selling  corporation,  to 
evade  the  law.  Such  a  conclusion  would  follow  logically 
from  the  acceptance  of  the  premise  that  the  transaction 
must  display  evidence  of  some  real  progress  in  the  process 
of  manufacture,  production,  or  distribution.  The  transfer 
of  goods  from  a  corporation  to  a  mere  agent  or  subsidiary 
might  not  be  an  essential  step  in  hastening  the  goods  in 
their  journey  toward  the  ultimate  consumer,  even  though 
the  buying  corporation  did  possess  an  independent  corpo- 
rate life. 

Another  difficulty  concerned  the  use  of  the  trade  accept- 
ance in  renewals.  It  is  clear  that,  if  merchants  should 
develop  the  practice  of  taking  new  bills  in  renewal  for 
those  maturing,  the  distinctive  quality  of  trade  acceptance, 
a  bill  quickly  redeemable  out  of  the  sale  proceeds,  would  be 
destroyed.  Such  a  renewal  trade  draft  would  be  much 
akin  to  that  arising  in  the  settlement  of  past-due  accounts. 

»  BtiUetin,  September  i,  191 6,  pp.  462-63. 
*  Ibid.,  January  i,  1918,  p.  33. 


DEVELOPMENT  OF  TRADE  ACCEPTANCE  123 

Accordingly  we  find  the  American  Acceptance  Council 
insisting  tliat 

if  an  extension  of  the  credit  is  given,  it  should  be  in  the  form  of 

a  promissory  note  with  interest.'' 

Opinions  vary  considerably  regarding  the  extent  to 
which  the  acceptance  has  been  thus  employed.  Regarding 
this  matter  the  American  Acceptance  Council  states :  ^ 

So  far  as  we  have  learned,  however,  these  practices  have  been 
largely,  if  not  entirely,  confined  to  houses  of  minor  importance, 
and  they  were  possibly  not  surprising  in  view  of  the  period  of 
credit  strain  which  was  endured  last  summer  and  autumn, 
particularly  in  the  textile  lines,  regarding  which  the  complaints 
were  most  general,  and  the  ignorance  or  lack  of  appreciation 
among  the  smaller  and  less  well-informed  commercial  concerns 
as  to  the  proper  use  of  the  trade  acceptance.  A  flabbiness  of 
commercial  moral  fibre  may  also  have  been  a  contributing  cause. 

These  were  a  few  of  the  difficulties  encountered  in  the 
endeavor  to  win  for  the  acceptance  a  reputation  as  the 
purest  type  of  commercial  paper.  Continuous  vigilance 
was  necessary  to  prevent  misuse.  But  problems  of  policy 
also  arose  which  retarded  its  rapid  development.  One  of 
these  related  to  the  number  and  strength  of  the  firms 
whose  allegiance  to  the  acceptance  should  be  sought. 

In  this  matter  the  financial  administration  was  con- 
fronted with  two  alternatives.  Either  the  acceptance  must 
be  pushed  zealously  among  all  firms  indiscriminately, 
irrespective  of  their  credit  standing,  and  for  multitudinous 
sorts  of  transactions;  or,  the  propaganda  must  be  begun 
slowly  and  cautiously,  confining  its  use  to  firms  with  high 
credit  rating  and  for  bona  fide  commercial  transactions. 
The  latter  was  the  only  feasible  policy.  Little  improve- 
ment over  former  methods  would  have  been  achieved  by 
the  adoption  of  the  acceptance  in  all  types  of  transactions. 

'  Cf.  Commercial  and  Financial  Chronicle,  April  2,  192 1,  p.  1345. 
» Ibid. 


124  FEDERAL  RESERVE  POLICY 

In  fact,  the  trade  acceptance  presented  some  grave  ele- 
ments of  danger  if  its  use  became  general.  One  of  these  — 
over-buying  —  may  easily  arise  in  situations  where  the 
banker  neglects  to  take  the  usual  precautions  of  examina- 
tion. This  depends  upon  the  fact  that  the  trade  accept- 
ance is,  in  form,  readily  negotiable.  Many  illustrations  of 
this  danger  were  presented  in  the  crisis  of  1920-21.  Some 
receiverships  were  explained  as  due  to  over-buying  encour- 
aged in  just  this  way.  When  the  seller  hesitated  to  tie  up 
more  funds  by  sales  on  credit,  he  would  be  requested  to 
continue  to  ship  goods,  taking  in  payment  an  acceptance, 
which,  it  was  argued,  could  be  discounted  easily.  The  very 
liquidity  of  the  trade  acceptance  created  the  temptation 
to  sell  in  excess  of  the  normal  volume.  When  the  crisis 
came,  many  firms  were  caught  with  excessive  stocks  on 
their  shelves  and  in  their  warehouses. 

It  is  true  that  a  more  conservative  bank-credit  policy 
would  have  served  to  check  such  excessive  activity  quite 
irrespective  of  the  sort  of  trade  paper  available.  But  the 
trade  acceptance  rendered  it  easier  for  the  banks  to  fur- 
nish the  unsound  credits.  Bankers  had  to  be  impressed 
again  and  again  with  the  fact  that  nothing  In  the  nature  of 
the  acceptance  justifies  refusal  to  take  due  precautions 
regarding  the  analysis  of  the  credit  standing  of  the  parties 
to  the  bill.  It  appears,  therefore,  fortunate  that  the  propa- 
ganda has  proceeded  slowly  and  cautiously,  that  in  the 
beginning  the  main  campaign  was  begun  among  the  strong, 
representative  firms  in  lines  of  industry  where  the  accept- 
ance was  expecially  applicable.  It  would  have  been  a  mis- 
take, perhaps  irretrievable,  to  have  tried  to  encourage  its 
use  among  firms  of  poor  credit  rating.  Care  also  had  to  be 
taken  not  to  push  the  acceptance  too  rapidly  into  indus- 
tries where  the  buyer  would  Interpret  its  use  as  a  reflection 
upon  the  soundness  of  his  financial  standing. 


DEVELOPMENT  OF  TRADE  ACCEPTANCE  125 

With  this  brief  discussion  of  the  difficulties  of  extending 
the  use  of  the  acceptance,  we  may  now  be  prepared  to  offer 
a  more  conclusive  answer  regarding  the  necessity  of  a  cen- 
tral banking  system  in  our  credit  structure.  Experience 
seems  to  have  proven  that,  no  matter  how  great  may  be 
the  advantages  ultimately  obtainable  from  the  use  of  the 
acceptance,  a  rapid  increase  in  its  use  would  have  brought 
many  evils.  Despite  the  encouragement  of  an  active  propa- 
ganda and  of  a  preferential  rate  of  rediscount,  the  trade 
acceptance  to-day  is  employed  relatively  infrequently. 
Without  a  strong  central  institution  to  foster  its  use  by 
rediscounts  and  direct  purchase,  its  sound  growth  must 
have  been  even  less  rapid.  No  small  part  of  its  present 
attainments  is  due  to  the  belief  that  the  reserve  banks  were 
ready  to  employ  their  funds  if  necessary  in  the  acquire- 
ment of  the  acceptances  of  prime  quality. 

A  final  query  yet  remains  for  brief  consideration.  What 
limitations  exist  regarding  the  amount  of  trade  accept- 
ances discountable  by  member  and  reserve  banks?  Let  us 
first  consider  the  matter  of  limitations  applicable  to  the 
member  banks  in  their  discounts  for  their  clients. 

It  will  be  recalled  that  section  5200  of  the  Revised 
Statutes  limits  the  amount  of  advances  to  any  one  person, 
firm,  or  corporation  to  an  amount  not  exceeding  ten  per 
cent  of  the  bank's  capital  and  surplus.  But  to  this  general 
statement  there  are  certain  exceptions.  Among  these  is 
"commercial  or  business  paper  actually  owned  by  the  per- 
son negotiating  the  same."  It  has  been  held  that  this 
exempts  the  trade  acceptance,  since  it  classifies  as  paper  of 
this  sort.  To  quote  from  an  Opinion  of  Counsel  in  the 
Bulletin:  * 

...  a  trade  acceptance  negotiated  in  good  faith  by  the  bona 
fide  owner  would  be  exempt  from  the  limitations  of  section  5200 
•  October  i,  19 18,  p.  974. 


126  FEDERAL  RESERVE  POLICY 

as  "commercial  or  business  paper  actually  owned  by  the  person 
negotiating  the  same." 

But  what  is  the  situation  with  respect  to  the  amount  of 
trade  acceptances  permissible  for  rediscount  by  a  reserve 
bank?  Section  13  of  the  act  limits  the  amount  of  paper 
bearing  the  name  of  any  one  borrower  to  an  amount  equal 
to  ten  per  cent  of  the  member  bank's  capital  and  surplus. 
But  an  exception  to  this  statement  is  made  by  the  follow- 
ing clause : 

This  restriction  shall  not  apply  to  the  discount  of  bills  of  ex- 
change drawn  in  good  faith  against  actually  existing  values. 

The  decisive  question  relates  to  the  question  of  when  a 
bill  will  be  considered  as  drawn  against  "actually  existing 
values."  Here  there  are  two  possibilities:  first,  when  the 
bill  is  discounted  before  acceptance;  second,  when  dis- 
counted subsequently  to  acceptance. 

Before  accepted  by  the  buyer,  the  bill  could  not  be 
interpreted  as  being  properly  secured  by  the  personal 
obligation  of  the  buyer.  Actually  existing  values  must 
then  be  proved  by  the  goods  themselves.  Unaccepted  bills 
do  not  form  an  exception  to  the  general  provision  unless 
title  can  be  shown  to  the  goods.  To  quote  from  an  Opinion 
of  Counsel  in  the  March  i,  191 7,  Bulletin:  ^ 

A  bill  of  exchange  discounted  before  acceptance  may  be  said 
to  be  drawn  against  actually  existing  value,  within  the  meaning 
of  section  13  of  the  Federal  Reserve  Act,  when  and  only  when 
it  is  accompanied  by  shipping  documents,  warehouse  receipts, 
or  other  papers  securing  title  to  the  goods  sold. 

An  accepted  bill,  however,  may  be  considered  as  drawn 
against  actually  existing  values 

if  drawn  against  the  drawee  at  the  time  of,  or  within  a  reason- 
able time  after,  the  shipment  or  delivery  of  the  goods  sold. 
'  Page  195. 


DEVELOPMENT  OF  TRADE  ACCEPTANCE  127 

[But]  In  this  latter  case  there  must  be  reasonable  grounds  to 
believe  that  the  goods  are  in  existence  in  the  hands  of  the  drawee 
either  in  their  original  form  or  in  the  shape  of  the  proceeds  of 
their  sale. 

Bills  accepted  before  sale  or  delivery  of  the  goods  could 
not  be  treated  as  drawn  against  actually  existing  values, 
however,  unless  the  goods  have  been  placed  in  storage 
under  the  order  of  the  drawee.  Such  goods  would  not  be  in 
the  possession  of  the  drawee  in  original  form  or  in  the 
shape  of  the  proceeds  of  the  sale.  The  essential  commer- 
cial nature  of  the  transaction  would  then  be  lacking. 


CHAPTER  VII 

AGRICULTURAL    CREDIT    UNDER    THE    FEDERAL 

RESERVE 

It  has  long  been  recognized  that  the  credit  needs  of  the 
agricultural  classes  differ  widely  from  those  of  the  purely 
commercial  or  mercantile  interests.  Among  other  charac- 
teristics agricultural  credit  needs  are  relatively  long-time, 
and  are  subject  to  pronounced  seasonal  variations.  It 
might  have  been  expected,  accordingly,  that  a  special  set 
of  institutions  would  have  been  evolved  in  this  country  to 
obtain  capital  from  the  investment  public  for  agricultural 
purposes.  For  the  most  part,  however,  these  institutions 
have  been  undeveloped  here,  and  the  national  banking 
institutions  with  which  the  farmer  has  dealt  have  been 
patterned  more  in  accordance  with  the  needs  of  commerce 
and  distribution.  Mercantile  and  distributive  credit 
requirements  are  far  different  from  those  of  agriculture. 

Justification  for  the  restrictions  relating  to  real  estate 
loans  in  the  National  Banking  Law,  however,  was  easy  to 
establish.  In  most  part  these  restrictions  were  the  result 
of  past  disasters  which  developed  when  bank  funds  were 
employed  to  promote  excessive  land  speculation.  From 
the  standpoint  of  logic,  also,  the  desirability  of  limiting 
loans  on  real  estate  security  seemed  clear.  Since  the  great 
bulk  of  the  deposits  of  the  national  banks  are  demand 
deposits,  should  not  institutions  whose  obligations  are 
payable  on  call  be  required  to  keep  their  assets  liquid? 
Had  not  past  experience  proved  the  slowness  of  real  estate 
paper?  At  any  rate,  these  restrictions  were  a  part  of  the 
National  Banking  Law. 


AGRICULTURAL  CREDIT  129 

It  has  sometimes  seemed  difficult  to  account  for  the 
marvelous  development  of  an  industry  thus  handicapped 
in  its  borrowing  facilities.  Explanation  is  twofold.  First, 
credit  has  been  obtained  largely  from  other  sources; 
second,  the  farmer's  past  credit  needs  were  relatively 
limited.  Land  was  cheap  and  farming  could  be  begun  with 
a  limited  amount  of  equipment.  As  cultivation  was  con- 
ducted on  a  more  and  more  intensive  scale,  new  capital 
was  required,  but  this  was  supplied  largely  out  of  past 
profits.  Farming  was  creating  in  large  measure  its  own 
funds  for  extensions.  The  industry  was  seasonal  in  its 
nature,  but  during  the  slack  seasons  employment  was  fur- 
nished by  the  work  of  further  clearing,  building  erection, 
extension  of  the  cultivated  area.  Goods  were  brought  on 
time  from  the  local  merchant,  and,  although  the  price 
paid  for  this  sort  of  credit  has  undoubtedly  been  high,  the 
farmer  has  been  somewhat  slow  to  perceive  that  the  cost 
of  credit  emerged  in  the  price  exacted  for  the  goods. 

Gradually,  however,  the  dependence  of  the  farmer  upon 
the  bank,  even  for  short-term  credit,  has  become  more 
intense.  Farm  machinery  is  costly,  and  the  amount 
required  by  modern  methods  is  increasing.  The  horse  is 
beginning  to  give  away  to  the  tractor;  this  is  an  era  of  the 
automobile,  motor  truck,  gasoline  engine,  steam  plough, 
artificial  fertilizer,  and  blooded  live  stock.  Between  1900 
and  19 10  census  figures  show  a  pcr-acre  increase  in  the 
value  of  farm  implements  and  machinery  of  61.8  per  cent. 
Development  of  new  land  has  become  more  difficult  with- 
out credit  aid.  Very  little  cheap  and  easily  cultivated  land 
is  now  available;  farm-land  extension  has  necessitated 
expensive  methods  of  cultivation,  such  as  dry-farming  and 
irrigation.  At  the  same  time  education  and  propaganda 
have  become  more  and  more  con\-incing  in  regard  to  the 
high  cost  of  credit  obtained  indirectly  from  the  store- 


130  FEDERAL  RESERVE  POLICY 

keeper.  Under  the  store  lien  system  the  farmer  obtaining 
credit  obliges  himself  to  sell  his  goods  through  the  store- 
keeper. He  obtains  customarily  low  prices  on  his  sales  and 
pays  very  high  prices  on  his  supplies.  In  an  article  on 
agricultural  credit  Professor  E.  W.  Kemmerer  quotes  Mr. 
George  K.  Holmes,  of  the  United  States  Department  of 
Agriculture,  as  follows:* 

The  rate  of  interest  on  the  liens  on  the  cotton  crop  of  the 
South,  it  is  safe  to  say,  probably  averages  40  per  cent  a  year. 
All  cotton  men  will  agree  that  it  is  at  least  that.  The  store  sys- 
tem of  the  South  is  a  sort  of  peonage;  that  is  what  it  amounts 
to  with  the  cotton  planter. 

With  similar  experiences  elsewhere,  the  desirability  as  well 
as  the  necessity  of  drawing  more  largely  upon  the  commer- 
cial bank  became  apparent. 

The  growing  needs  of  bank  credit  granted,  we  may  next 
inquire  as  to  the  ability  of  existing  institutions  to  supply 
it.  Attention  has  already  been  called  to  the  provision  of 
the  National  Banking  Law  limiting  loans  on  real  estate 
security.  But  State  bank  restrictions  were  usually  not 
onerous.  It  was  often  not  so  much  a  matter  of  the  legal 
impossibility  of  making  the  credit  advance  as  of  the  finan- 
cial undesirability  to  the  banker  of  the  farmer's  paper.  As 
previously  mentioned,  agricultural  credit  of  necessity  must 
be  relatively  long-time.  The  farmer  is  engaged  in  a  pro- 
ducing activity;  not  until  he  has  a  product  in  salable  form 
is  he  in  shape  to  make  repayment  of  the  loan.  A  note 
drawn  to  obtain  funds  for  the  purchase  of  cattle  or  seed- 
grain  cannot  be  redeemed  out  of  the  sale  proceeds  until 
sufficient  time  has  elapsed  for  the  cattle  to  be  fattened  or 
for  the  grain  to  become  the  harvested  crop.  The  farmer's 
operations  are  much  more  akin  to  those  of  the  manufac- 

'  Cf.  E.W.  Kemmerer,  "Agricultural  Credit  in  the  United  States,"  ^mertcaw 
Economic  Review,  December,  19 12,  pp.  852-72. 


AGRICULTURAL  CREDIT  131 

turer  than  to  those  of  the  retailer,  jobber,  or  wholesaler. 
Three  months  is  ordinarily  a  very  short  maturity  for  the 
average  farmer's  note. 

It  should  be  borne  in  mind  that  it  may  be  much  more 
hazardous  for  the  farmer  to  depend  upon  renewals  than 
for  the  retailer  or  wholesaler.  It  may  be  inconvenient  for 
either  of  the  latter  to  have  their  notes  called.  But  a  forced 
sale,  by  marking  down  prices,  is  usually  possible.  Goods 
unsold  exist  presumably  in  salable  form.  Not  until  after 
the  harv'esting  season,  however,  is  the  farmer  in  possession 
of  readily  marketable  goods. 

But  is  it  legitimate  for  the  farmer  to  depend  upon  the 
commercial  bank  for  such  credit  needs?  Has  he  a  right  to 
insist  that  the  commercial  bank  supply  capital  not  return- 
able in  a  very  short  period?  The  answer  is  several  fold. 
Many  of  his  needs  are  for  purposes  much  more  quickly 
and  easily  liquidated  than  the  sort  of  advances  which  in 
the  early  days  created  the  prejudice  against  real  estate 
loans.  Then  our  difficulties  arose  in  the  purchase  of  land 
before  cultivation  was  practicable.  Loans  for  the  purchase 
of  machinery  or  cattle  are  far  different  in  character.  But 
irrespective  of  all  this,  the  commercial  bank  supplies  much 
more  capital  to  the  merchantile  interests  for  developmental 
purposes  than  is  ordinarily  supposed.  The  stock  and  bond 
investments  of  the  commercial  bank  have  been  enormous. 

But  at  any  rate  the  commercial  bank  may  be  the  only 
institution  available  for  the  farmer.  He  cannot  offer  his 
stock  or  bonds  to  the  investment  public  through  the  in- 
strumentality of  the  bond  house.  Neither  have  there  been 
perfected  here  cooperative  credit  institutions  for  the  pur- 
pose of  appealing  to  the  investing  public.  In  Europe,  by 
way  of  contrast,  such  associations  have  accomplished 
much.  Details  of  their  organization  vary.  But  usually  the 
plan  involved  the  acquirement  by  the  society  of  the  mort- 


132  FEDERAL  RESERVE  POLICY 

gages  on  the  property  of  the  members  who  desire  advances. 
On  the  basis  of  these  mortgages,  the  society  offers  its 
paper  to  the  public.  The  investor  is  thus  protected  by  the 
collective  security  of  the  members'  obligations.  But  in 
America  orgainzations  had  not  even  developed  to  such  an 
extent  as  to  preserve  for  the  agricultural  borrower  funds 
saved  by  members  of  his  own  class.  Savings  bank  invest- 
ments, built  up  in  part  from  farmer's  deposits,  have  been 
made  customarily  in  corporate  bonds  of  industrial  enter- 
prises. In  the  course  of  time  such  institutions  as  the  Land- 
schaften  in  Germany  may  take  root  here.  But  sudden 
development  cannot  be  expected.  In  the  meanwhile  the 
commercial  bank  must  be  organized  to  offer  legitimate 
credit  aid  to  the  farmer. 

Not  only  are  the  farmer's  requirements  long-time ;  they 
are  also  subject  to  pronounced  seasonal  fluctuations. 
Banks  which  commit  their  funds  to  industrial  undertak- 
ings in  the  off  season  may  find  themselves  unable  to  take 
care  of  the  farmer  during  the  busy  spring-planting  or  fall 
crop-moving  period.  Deposits  with  banks  in  the  financial 
centers  could  normally  be  withdrawn  without  difficulty. 
But  during  the  season  of  agricultural  strain  the  security 
market  might  be  temporarily  low  and  render  inadvisable 
liquidation  of  bond  investments.  Limitations  on  the 
farmer's  ability  to  sell  commercial  paper  in  the  open  market 
already  have  been  mentioned.  The  frequent  preference 
of  the  banker  for  industrial  rather  than  for  agricultural 
clients  may  be  traced  in  part  to  the  unsteady  credit  appe- 
tite of  the  agricultural  borrower. 

The  special  needs  of  the  farmer  understood,  a  next  in- 
quiry was  to  ascertain  the  means  by  which  relief  could  be 
granted.  EveryAvhere  the  hope  was  expressed  that  there 
should  be  a  continued  development  of  cooperative  agri- 
cultural credit  societies.    But  what  role  should  the  com- 


AGRICULTURAL  CREDIT  133 

mercial  national  bank  play  in  all  this?  Of  course  it  was 
insisted  that  the  legal  restrictions  of  the  National  Banking 
Law  be  modified.  It  was  asserted  that  the  real  estate  loan 
limitations  were  driving  business  from  national  banks 
to  State  banks,  and  that  attempts  to  avoid  this  loss  of 
business  explained  many  subterfuges  and  indirect  methods 
of  evading  the  terms  of  the  statute.  Frequently  the  stock- 
holders of  a  national  bank  would  organize  a  State  bank  in 
the  same  building  and  under  the  same  roof.  The  same  set 
of  officers  would  keep  the  books  of  the  two  institutions, 
direction  would  be  harmonized,  clients  would  be  mutual. 
Only  in  one  respect  were  they  separate  institutions,  and 
that  was  in  the  fact  of  their  separate  corporate  life.  Bor- 
rowers on  real  estate  mortgages  would  be  "recommended  " 
to  the  "other"  bank  under  the  archway.  To  the  extent 
that  the  law  created  subterfuges  of  this  sort,  the  chief 
result  was  to  lessen  the  size  of  the  national  banking  system 
and  add  to  the  prestige  of  the  State  banks. 

It  could  also  be  argued  that  the  restrictions  of  the  law, 
in  many  situations,  lessened  rather  than  increased  the 
soundness  of  national  bank  assets.  National  banks  could 
not  loan  on  real  estate  security,  but  were  permitted  to  dis- 
count the  unsupported  note  of  a  farmer.  Before  the  matur- 
ity of  the  unmortgaged  note,  the  borrower  might  execute 
a  lien  in  another  borrowing  operation  in  favor  of  a  State 
bank.  In  case  of  the  insolvency  of  the  borrower,  the 
national  bank's  claim  to  the  property  would  be  inferior  to 
that  of  the  State  institution.  The  national  bank  could 
have  acquired  a  prior  lien  had  it  been  permitted  at  the 
time  of  the  loan  to  demand  a  mortgage. 

But  one  fact  relating  to  the  safety  of  farm  loans  seems 
strangely  to  have  been  overlooked  by  many  students  of 
agricultural  credit.  It  is  true  that  in  tiie  past  some  of  our 
most  severe  crises  were  due  to  over-speculation  in  land.  It 


134  FEDERAL  RESERVE  POLICY 

is  also  true  that  farm  borrowings  are  for  a  relatively  long 
period  of  time  and  that  the  commercial  bank  deposits 
should  be  protected  by  easily  liquidated  holdings.  Still,  in 
past  depressions  the  speed  with  which  agriculture  has 
recovered  often  has  been  astounding.  Poor  years  may 
come,  markets  or  crops  may  fail,  but  the  nucleus  of  the 
farm  organization  remains  intact.  It  is  the  exceptional 
case  to  find  the  farm  in  a  good  agricultural  district  totally 
deserted  and  rendered  destitute  of  equipment.  It  is  seldom 
abandoned  as  may  be  the  case  in  an  unprofitably  estab- 
lished factory  or  shop.  And  steadily  land  values  have 
increased.  The  big  drops  in  this  country  have  been  due 
usually  to  temporary  speculative  reaction  and  represent 
only  momentary  oscillations  on  a  steadily  ascending  curve. 

These  considerations  should  not  be  interpreted  as  an 
argument  for  the  total  removal  of  restrictions  on  real 
estate  loans.  The  commercial  bank  must  keep  its  assets 
in  fairly  liquid  shape ;  it  cannot  base  its  advances  on  ulti- 
mate prospects.  But  no  large  proportion  of  a  bank's 
assets  need  ordinarily  be  liquidated  suddenly.  Would 
there  not  be  justification,  accordingly,  for  permitting  to  a 
limited  extent  investments  protected  by  real  estate 
mortgages? 

But  what  provisions  should  have  been  inserted  in  the 
Federal  Reserve  Act  relating  to  agricultural  credit?  The 
reserve  banks  were  to  be  bankers'  banks  to  guarantee, 
particularly  in  periods  of  emergency,  the  redeemability  of 
member  bank  assets.  They  were  to  be  the  ultimate  reserve 
holding  institutions  of  the  country.  It,  accordingly,  was  a 
matter  of  absolute  necessity  that  they  maintain  their  own 
assets  liquid.  The  paper  discountable  was  to  be  of  the 
short-time,  automatically  liquidating  variety.  What  room 
would  there  be  in  the  Federal  Reserve  Act  for  a  provision 
rendering  it  possible  for  a  member  bank  to  lend  on  real 


AGRICULTURAL  CREDIT  135 

estate  security?  Logically  none,  unless  such  paper  were 
eligible  for  rediscount  or  direct  purchase.  A  change  in  the 
law  not  concerning  directly  the  operations  of  reserve  banks 
should  appear  in  the  form  of  an  amendment  to  the  National 
Bank  Act.  Nevertheless,  a  provision  of  this  sort  did 
appear  in  the  Federal  Reserve  Act.  In  addition  to  this 
modification  of  the  previous  legal  difficulty  regarding  real 
estate  loans,  it  would  be  expected  that  something  would 
have  been  attempted  in  the  way  of  removing  the  financial 
undesirability  of  agricultural  paper.  Accordingly,  certain 
preferences  are  granted  agricultural  over  other  sorts  of 
commercial  paper  in  the  rediscount  operations  of  reserve 
banks.     ' 

We  may  now  quote  the  provisions  of  the  Federal  Reserve 
Act  of  special  importance  to  the  agricultural  borrower. 
The  most  important  provisions  of  the  statute  are  three. 
The  first  of  these,  in  section  24,  is  not  related  to  rediscount- 
ing.  The  original  act  read  as  follows  in  this  section : 

Any  national  banking  association  not  situated  in  a  central 
reserve  city  may  make  loans  secured  by  improved  and  unen- 
cunihcrcd  farm  land  situated  within  its  P^edera!  reserve  district, 
but  no  such  loan  shall  be  made  for  a  longer  time  than  five  years, 
nor  for  an  amount  exceeding  fifty  per  centum  of  the  actual 
value  of  the  property  ofTered  as  security.  Any  such  bank  may 
make  such  loans  in  an  aggregate  sum  equal  to  twenty-five  per 
centum  of  its  capital  and  surplus  or  to  one-third  of  its  time 
deposits  and  such  banks  may  continue  hereafter  as  heretofore 
to  receive  time  deposits  and  to  pay  interest  on  the  same. 

Then  followed  a  statement  to  the  efTect  that  the  Federal 
Reserve  Board  could  add  to  the  list  of  cities  in  which 
national  banks  would  not  be  permitted  to  make  loans. 
Except  for  this,  this  section  is  not  related  in  any  direct  way 
to  the  reserve  mechanism. 

This  section  was  later  amended.  Under  certain  restric- 
tions banks  in  the  permitted  cities  may  make  loans  on  real 


136  FEDERAL  RESERVE  POLICY 

estate  as  well  as  upon  farm-land.  Also,  the  bank  advanc- 
ing the  funds  need  not  be  situated  within  the  same  dis- 
trict, provided  the  real  estate  or  farm-land  is  "located 
within  one  hundred  miles  of  the  place  in  which  such  bank 
is  located." 

The  second  of  the  agricultural  credit  provisions  is  found 
in  the  rediscounting  section,  13.  Whereas  eligible  com- 
mercial paper  must  have  a  maturity  of  three  months  or  less, 

notes,  drafts,  and  bills  drawn  or  issued  for  agricultural  purposes 
or  based  on  live  stock  and  having  a  maturity  not  exceeding  six 
months  may  be  discounted  in  an  amount  to  be  limited  to  a  per- 
centage of  the  capital  of  the  Federal  reserve  bank,  to  be  ascer- 
tained and  fixed  by  the  Federal  Reserve  Board. 

This  is  the  most  important  concession  to  the  special  needs 
of  the  agricultural  interests  to  be  found  in  the  act.  The  ac- 
complishments under  this  section  later  will  be  considered. 
The  last  of  these  provisions  of  special  importance  to 
agriculture  is  to  be  found  in  the  amendment  to  the  act 
bestowing  upon  national  banks  power  to  accept  certain 
types  of  domestic  bills  and  drafts.  Since  no  specific  prefer- 
ential treatment  is  hereby  granted  agricultural  paper,  it 
might  not  appear  to  warrant  mention  in  a  chapter  devoted 
to  agricultural  credit.  But  the  domestic  acceptance  should 
prove  peculiarly  useful  in  removing  many  difficulties 
hitherto  encountered  in  the  marketing  of  farm  crops.  As 
will  appear  more  clear  later,  the  bank  acceptance  is  a 
method  whereby  the  client's  bank  is  enabled  to  aid  him  to 
secure  funds  from  other  banks.  If  the  local  banker  is  tem- 
porarily without  funds  and  cannot  discount  the  applicant's 
note,  it  may  agree  to  accept  a  draft  drawn  against  it  by 
the  prospective  borrower.  This  accepted  draft  may  be 
peddled  around  the  market  and  because  of  the  financial 
standing  of  the  acceptor  should  find  a  ready  market.  It  is 
as  if  the  local  bank  had  guaranteed  the  note  of  the  client. 


AGRICULTURAL  CREDIT  137 

The  farmer  is  in  peculiar  need  of  reaching  the  outside 
investment  market  in  some  such  way  as  this.  The  seasonal 
character  of  agricultural  operations  often  creates  a  strain 
too  severe  for  the  local  banker.  But  the  farmer  unassisted 
has  no  way  of  securing  the  use  of  idle  funds  available  else- 
where. He  cannot  have  his  notes  peddled  over  the  country 
by  the  note  broker.  His  standing  in  the  investment  mar- 
ket is  not  such  as  to  permit  this.  In  view  of  these  facts  it 
seems  strange  to  the  writer  that  the  special  applicability 
of  the  acceptance  to  the  farmer's  marketing  problems  so 
frequently  has  been  overlooked. 

With  these,  the  pertinent  provisions  of  the  statute,  we 
may  next  inquire  as  to  the  agricultural  credit  policy  of  the 
reserve  management.  Has  it  adopted  a  liberal  or  illiberal 
policy  in  the  administration  of  its  duties?  Inasmuch  as  a 
prime  function  of  the  Federal  Reserve  Board  is  to  define 
eligible  paper,  we  may  first  test  its  liberality  by  examining 
some  of  its  most  important  decisions  so  far  as  these  have  to 
do  with  the  admission  of  paper  to  the  agricultural  class. 
Undue  strictness  and  conservatism  would  tend  to  restrict 
the  willingness  of  member  banks  to  make  loans  of  needed 
maturity  to  the  applicant  farmers. 

A  first  problem  had  to  do  with  the  interpretation  of 
these  words  of  the  statute,  "based  on  live  stock."  A 
strict  construction  might  have  held  "based  on  live  stock" 
to  be  synonymous  with  "secured  by  live  stock."  The 
Board  ruled,  however,  that  the  farmer's  note  need  not  be 
protected  by  a  chattel  mortgage  on  the  stock. '  "  Based  on  " 
is  thus  made  to  refer  to  the  purposes  of  the  farmer's  note. 
If  the  funds  were  borrowed  in  order  to  acquire  the  stock 
the  stock  comprises  part  of  the  assets  of  the  farmer  guan 
anteoing  his  ability  to  pay.  This  ruling  made  possible,, 
accord ingly.thcemployment  of  less  red  tape  in  the  advance 
of  funds  to  the  farmer. 

'  Sec  Bulletin,  ]u\\v  i,  1915,  ().  72. 


133  FEDERAL  RESERVE  POLICY 

A  second  interesting  ruling  related  to  the  eligibility  of 
notes  given  by  farmers  in  payment  for  tractors  to  be  used 
in  agricultural  operations.  It  is  to  be  assumed,  of  course, 
that  the  tractors  were  not  intended  to  be  resold.  The  main 
question  here  was  whether  tractors  were  to  be  classified  as 
a  permanent  fixed  investment.  If  they  were  so  classified, 
the  farmer's  note  would  not  be  rediscountable.  It  would 
appear  as  if  much  justification  would  exist  for  such  a  clas- 
sification. It  is  to  be  expected  that  the  life  of  the  tractor 
would  extend  over  several  seasons,  and  it  could  not  be 
regarded  as  an  expense  chargeable  to  the  revenues  of  any 
one  season.  Would  not  expenditures  of  this  sort  correspond 
to  those  invested  in  permanent  drainage  improvements,  in 
silos,  and  in  buildings? 

The  act,  however,  stipulated  as  eligible  paper  that 
based  upon  live  stock.  Would  it  be  possible  to  show  the 
similarity  of  tractor  paper  to  that  of  live-stock  paper? 
If  the  law  was  to  be  construed  strictly,  this  would  appear 
to  offer  the  sole  means  of  holding  such  paper  agricultural. 
This  means  was  seized  upon  by  the  Board.  In  the  words  of 
the  ruling:  ^ 

Horses  and  mules  bought  for  farm  work  are  purchased  with 
several  years'  use  in  view,  yet  there  can  be  no  question  that  a 
note  given  by  a  farmer  in  payment  of  a  pair  of  mules  to  be  used 
in  farm  work,  maturing  within  six  months,  is  eligible  as  agri- 
cultural paper.  Where  tractors  are  used  to  supplement  the  work 
of  horses  or  mules  or  are  used  altogether  instead  of  these  ani- 
mals, it  seems  to  the  Board  that  notes  given  by  farmers  for  the 
purchase  price  of  tractors,  and  maturing  within  six  months, 
should  be  admitted  to  discount  as  agricultural  paper,  .  .  . 

Implement  paper,  however,  would  present  a  situation 
in  which  solution  could  not  be  found  by  stressing  the 
similarity  to  live-stock  paper.  Very  early  the  Board  was 
compelled  to  decide  between  a  wide  and  a  narrow  con- 

'  BulleUn,  April  i,  1918,  pp.  309-10. 


AGRICULTURAL  CREDIT  139 

struction  of  the  act.  Decision  in  this  matter  comes  closer 
to  indicating  the  desire  of  the  Board  to  render  as  available 
to  the  farmer  as  possible  the  facihties  of  the  reserve 
system. 

The  Board  admitted  '  that  it  was 

a  very  close  question  whether  agricultural  implements  are  to 
be  considered  as  permanent  improvements  or  as  a  part  of  the 
cost  of  operation. 

But  as  ground  for  liberality 

it  must  be  considered  that  machinery  of  this  kind  is  not  of  a 
permanent  character.  It  wears  out  rapidly  and  in  most  cases 
has  to  be  replaced  within  a  comparatively  short  time,  so  that  it 
may  be  assumed  that  a  certain  amount  of  money  would  be  spent 
annually  and  regularly  for  the  purchase  and  replacement  of 
machinery  of  this  kind. 

It  seems  to  the  writer  that  it  is  extremely  doubtful 
whether  in  other  situations  so  much  stress  would  be  placed 
upon  the  fact  that  capital  expenditures  may  be  distrib- 
uted fairly  evenly  over  a  series  of  years.  Would  a  manu- 
facturer's notes  be  eligible  for  the  purpose  of  constructing 
buildings  in  such  a  way  as  to  keep  the  erection  costs 
approximately  equal  from  year  to  year?  Would  the  equip- 
ment notes  of  a  railroad  company  be  eligible  because  the 
replacement  costs  for  rolling  stock  might  display  yearly 
uniformity? 

Prophetic  vision  is  not  required  to  answer  these  queries 
in  the  negative.  The  real  intent  of  the  Board  appears  to  be 
expressed  in  the  following:^ 

As  the  Board  by  its  regulations  does  not  desire  unnecessarily 
to  restrict,  but  rather  to  encourage,  the  facilities  to  be  given,  as 
far  as  that  may  be  done  consistently  with  prudence,  it  would 
appear  that  the  wider  interpretation  in  this  case  should  be 
given.  .  .  . 

'  Bulletin,  February  i,  1916,  p.  67. 
»  Ibid. 


140  FEDERAL  RESERVE  POLICY 

Certainly  in  such  cases  the  burden  of  doubt  is  not  placed 

against  the  farm  borrower. 

Would  it  make  any  difference,  however,  who  was 
the  presenter  of  the  note  for  discount?  Would  the  Board 
be  obliged,  for  instance,  to  refuse  to  admit  as  agricultural 
the  paper  presented  by  a  dealer,  and  insist  that  the  maker, 
the  farmer,  must  be  the  presenter  of  the  paper?  In  case 
the  farmer  had  given  his  note  to  the  dealer,  which  note  had 
been  discounted,  would  eligible  agricultural  paper  have 
been  created?  Or,  since  the  facilities  are  granted  to  the 
dealer  and  not  to  the  farmer,  must  it  not  be  classified  as 
non-agricultural  paper? 

It  is  clear  that  the  purpose  of  the  act  was  to  give  "spec- 
ial facilities  to  farmers."  ^  The  question,  then  becomes 
this  —  How  can  these  facilities  best  be  granted?  In  cer- 
tain situations  the  farmer  might  be  accommodated  to 
advantage  by  encouraging  the  method  of  note-giving  to 
the  dealer.  Such  a  note  would  be  double-name,  and  very 
likely  would  be  discounted  at  a  cheaper  rate  than  the 
farmer's  own  single-name  note.  The  Board  ought  not  to 
insist  upon  the  more  expensive  means  of  financing  agri- 
cultural operations.  It  ruled  accordingly  that  to  classify 
as  agricultural  paper,  the  maker  of  the  note  need  not  be 
the  presenter.'^ 

But  let  us  return  to  other  cases  in  which  the  question  at 
issue  was  whether  or  not  the  expenditure  was  for  fixed- 
capital  or  long-time  developmental  purposes.  One  im- 
portant problem  was  the  classification  of  notes  given  for 
the  purpose  of  draining  and  tilling  farm-land.  How  liquid 
would  such  notes  be?  How  soon  would  such  expenditures 
contribute  to  increased  farm  revenues?  Questions  of  this 
sort  might  well  involve  the  amount  of  expenditures  pro- 

'  Bulletin,  February  I,  191 6,  p.  67. 
*Jbid. 


AGRICULTURAL  CREDIT  141 

portionately  to  the  total  farm  investment.  The  Board's 
ruling,  however,  made  the  decision  depend  upon  the  nature 
of  land.   In  its  own  language:  * 

cases  may  arise  in  the  reclamation  of  swamp  lands  where  such 
lands  could  not  be  treated  as  farm  land  until  expensive  drainage 
systems  have  been  installed.  In  such  case  there  is  doubt  of  the 
eligibility  of  the  notes,  the  proceeds  of  which  are  used  for  this' 
purpose.  Where,  however,  the  land  drained  is  already  in  use  as 
farm  land,  the  draining  may  be  treated  as  incidental  to  the  culti- 
vation of  the  land,  and  notes  given  for  such  purpose  may  be 
rediscounted  as  agricultural  paper. 

The  liberality  of  this  ruling  is  easily  apparent.  Ques- 
tions relating  to  the  amount  of  such  expenditures  and 
their  nature,  are  not  even  to  be  raised.  The  only  criterion 
is  whether  or  not  the  land  previously  has  been  under  culti- 
vation. But  even  in  the  case  of  cultivated  land,  if  such 
operations  as  draining  do  not  constitute  permanent  im- 
provements —  fixed-capital  expenditures,  in  other  words 
—  it  is  difficult  to  know  what  might  be.  Such  paper  may 
vary  widely  from  the  automatically  liquidating  variety. 

A  similar  sort  of  decision  is  raised  in  connection  with 
farmers'  paper  arising  in  the  purchase  of  dairy  cattle.  In 
one  query  to  the  Board  it  was  stated  ""  that  the 

cows  will  be  used  as  dairy  cattle  which  will  be  retained  for  a 
considerable  length  of  time  ^  to  produce  milk,  butter,  cheese,  etc., 
and  that  the  loan  is  not  made,  strictly  speaking,  for  the 
"breeding,  raising,  fattening,  and  marketing  of  live  stock." 

Nevertheless,  the  Board  held  such  paper  agricultural 
since  "live  stock  includes  cows." 

It  would  have  been  very  easy,  however,  to  hold  that 
dairy  cows,  to  be  hold  permanently,  were  not  "livestock" 
within  the  meaning  of  the  act.    Live  stock  is  ordinarily 

'  Bulletin,  August  i,  19 18,  pp.  743-44. 
'  Bulletin,  March  i,  1916,  p.  112. 
^  Italics  arc  the  writer 's. 


142  FEDERAL  RESERVE  POLICY 

sold  when  fattened.  In  this  sense  live-stock  paper  is  auto- 
matically liquidating.  Dairy  cattle,  however,  may  not  be 
sold,  but  contribute  to  income  slowly.  Their  present  sell- 
ing price  represents  the  capitalization  of  their  future  earn- 
ings. In  reality,  dairy  cattle  is  as  much  a  fixed-capital 
expenditure  as  that  required  to  purchase  a  building  which 
is  to  be  rented,  or  a  locomotive  which  is  gradually  to  earn 
its  own  replacement  cost. 

These  are  some  of  the  more  interesting  and  illustrative 
of  the  Board's  rulings  bearing  upon  the  differentiation 
between  agricultural  and  non-agricultural  commercial 
paper.  Our  next  query  concerns  the  method  of  identifica- 
tion of  agricultural  paper.  Has  so  much  red  tape  been 
required  in  the  process  that  the  farmer  is  harassed  ? 

This  question  relating  to  implement  paper  was  answered 
by  the  Federal  Reserve  Board,  December  30,  1915/  We 
may  quote  the  following : 

The  nature  of  the  bill,  the  name  of  the  acceptor,  and  the  name 
of  the  drawer  would  probably  indicate  that  a  farmer  was  the 
purchaser  and  an  implement  dealer  the  seller  of  the  goods. 
However,  the  purchasing  member  bank  will  have  to  satisfy 
itself  in  some  satisfactory  way  that  the  bill  is  substantially 
of  an  agricultural  character.  A  simple  memorandum  attached 
to  the  bill,  stating  that  the  bill  was  drawn  in  payment  of  agri- 
cultural implements,  signed  either  by  the  acceptor  or  the  drawer, 
would  probably  be  considered  sufficient  evidence  by  the  member 
bank  and  the  Federal  Reserve  Bank. 

It  will  be  recalled  that  by  the  terms  of  the  statute  the 
amount  of  agricultural  paper  purchased  by  a  reser\^e  bank 
could  not  exceed  a  certain  percentage  of  its  capital  stock. 
The  amount  of  this  percentage  was  to  be  fixed  by  the 
Federal  Reserve  Board.  Some  light  may  be  thrown  upon 
the  Board's  attitude  by  noting  the  percentages  thus  estab- 
lished. In  every  case  this  percentage  has  been  fixed  at 
ninety-nine  per  cent.  This  appears  very  liberal, 

•  Bulletin,  February  i,  1916,  pp.  67-68. 


AGRICULTURAL  CREDIT  143 

In  still  another  way  a  ruHnp^  of  the  Board  was  such  as  to 
make  more  difficult  chari^es  that  it  was  ultra-technical 
or  bureaucratic  in  matters  relating  to  farm  credit.  In  an 
informal  Ruling  in  the  June,  1915,  Btdlethi,^  it  held  that  a 
member  bank  need  not  make  an  exhaustive  inquiry  as  to 
the  use  of  funds  borrowed  in  order  that  the  paper  might  be 
classed  as  agricultural.  It  need  only  satisfy  itself  that  the 
primary  purpose  was  agricultural.  The  agricultural  char- 
acter of  the  paper  would  not  be  destroyed  even  if  it 
should  be  established  that  part  of  the  funds  were  em- 
ployed for  the  support  of  the  borrower's  family. 

So  far  as  commerce  and  industry  are  concerned,  the 
reserve  system  has  never  endeavored  to  regulate  the  inter- 
est or  discount  rates  member  banks  might  exact.  In  the 
marketing  of  farm  crops,  we  find  the  sole  exception.  Dur- 
ing a  portion  of  its  life,  reserve  banks,  in  order  to  facilitate 
crop  marketing,  established  a  discount  rate  lower  than  for 
other  classes  of  paper.  But  member  banks  could  redis- 
count at  this  low  rate  only  on  condition  that  they  would 
pass  this  advantage  on  to  the  borrower.  The  borrower's 
paper  was  not  rediscountable  if  the  member  bank  origi- 
nally exacted  a  rate  higher  than  a  certain  published  maxi- 
mum. This  was  the  special  "commodity"  rate. 

The  establishment  of  a  special  commodity  rate  grew  out 
of  the  endeavor  of  thereserve  administration  in  thesummer 
of  191 5  to  be  prepared  for  any  contingencies  which  might 
arise  in  connection  with  the  marketing  of  the  cotton  crop. 
All  were  aware  of  the  disaster  which  befell  the  South  and 
the  entire  country  the  year  previous  because  of  the  sudden 
cutting  off,  at  the  outbreak  of  the  World  War,  of  the 
European  market  for  the  South's  most  important  article 
of  commerce.  Accordingly,  a  committee  of  the  Board 
sought  to  inform  itself  in  the  summer  of  1915  regarding 

'  Page  72. 


144  FEDERAL  RESERVE  POLICY 

conditions  in  that  industry.  It  learned  that  the  reduction 
in  cotton  acreage  had  been  such  that  ample  storage  facili- 
ties were  available  in  the  South  for  the  warehousing  of  such 
portion  of  the  crop  as  might  have  to  be  carried  over.  Hav- 
ing ascertained  that  the  physical  means  were  at  hand  for 
the  orderly  marketing  of  the  crop,  it  appeared  that  the 
special  need  was  to  ensure  a  sufficiency  of  bank  credit  to 
finance  the  carry-over. 

The  committee  entertained  the  view  that  warehouse  receipts 
for  cotton,  grain,  and  other  staple  non-perishable  agricultural 
products  of  a  readily  marketable  character,  form  an  excellent 
basis  for  bank  loans. ^ 

Accordingly,  on  September  3,  19 15,  the  Board  issued  regu- 
lations according  to  which  notes  secured  by  non-perishable 
staples  receive  the  benefit  of  the  low  special  rate. 

Since  the  Board  was  especially  desirous  that  the  advan- 
tage of  this  low  rate  should  be  passed  on  by  the  member 
bank  to  its  customers,  it  was  provided  that  only  paper 
should  be  eligible  for  rediscount  at  the  special  rate  upon 
which  the  member  bank's  charge  was  not  more  than  six 
per  cent  per  annum  inclusive  of  all  commissions.  This 
special  rate  was  not  to  be  applied  exclusively  to  cotton, 
but  might  serve  for  other  staple  commodities  such  as 
grain,  cotton,  and  wool.  The  rate  might  be  adopted  by  any 
reserve  bank,  and  was  not  confined  to  any  one  district. 

To  illustrate  the  manner  in  which  credits  might  be 
granted,  the  following  selection  is  quoted  from  a  statement 
by  the  Secretary  of  the  Treasury  on  September  3,  1915:' 

A  borrower  asks  his  local  bank  for  a  loan  on  his  note,  secured 
by  warehouse  receipts  for  cotton.  If  the  bank  is  satisfied  that 
the  cotton  is  in  a  responsible  warehouse,  properly  insured,  and 
that  the  note  is  good,  it  may  make  the  loan.   If  the  local  bank 

'  Cf.  Report  of  the  Federal  Reserve  Board  for  1915,  p.  7. 
'Bulletin,  October  i,  19 15,  p.  301. 


AGRICULTURAL  CREDIT  145 

charges  the  borrower,  a  rate  of  interest,  inckidinp;  commission, 
not  exceeding  6  per  cent  per  annum,  it  may  indorse  the  note 
over  to  the  Federal  reserve  bank  of  its  district,  and  the  Federal 
reserve  bank  may  advance  to  the  local  bank  the  full  amount  of 
the  loan.  The  rate  of  interest  which  the  Federal  reserve  bank 
will  charge  the  local  bank  will  be  sufficiently  low,  say  3  per  cent, 
to  enable  the  local  bank  to  make  loans  at  a  rate  of  interest  not 
exceeding  6  per  cent  per  annum,  and  have  a  liberal  margin  of 
profit  on  such  transactions. 

The  principal  problem  relating  to  the  applicability  of 
this  special  rate  was  that  of  the  definition  of  "readily 
marketable  staples."  By  this  phrase,  the  intent  was 
merely  to  confine  the  use  of  funds  obtained  from  the 
reserve  bank  to  goods  capable  of  being  graded,  and  for 
which  a  wide  market  usually  existed,  a  market  not  ultra- 
sensitive to  changes  in  consumers'  whims  and  tastes.  In 
one  ruling  it  was  held  that  ^ 

Potatoes,  properly  graded  and  packed  and  stored  in  a 
weatherproof  and  responsible  warehouse,  as  evidenced  by  its 
receipt,  would  undoubtedly  constitute  a  readily  marketable, 
non-perishable  staple  within  the  meaning  of  the  regulation. 

Although  the 

so-called  commodity  rate  was  established  some  time  ago  in 
order  to  give  a  preferential  rate  particularly  to  farmers  during 
the  crop-moving  season  ^ 

it  was  ruled  that  manufactured  goods,  such  as  cotton  yam 
and  flour,  were  staples  within  the  meaning  of  regulations 
dealing  with  this  class  of  paper.^  But  such  manufactured 
goods  must  be  non-perishable  and  have  a  wide  ready 
market. 

They  must  be  goods  generally  produced  and  well  established 
in  commerce,  not  an  extraordinary  or  unusual  commodity  for 
which  there  is  no  ready  market. 

'Cf.  Bulletin,  Aupiist  i,  1917,  pp.  614-15. 

'Bulliiin,  January  I,  I9I(S,  p.  30. 

3  Sec  Regulations  for  Scries  of  1915  and  Bulletin,  October  i,  1916,  p.  523. 


146  FEDERAL  RESERVE  POLICY 

The  use  made  of  the  commodity  rate  is  indicated  by  the 
following  figures :  ^ 

Septembers,  1915,  to  December  31,  1915 $10,315,000 

January      i,  1916,  to  December  31,  1916 16,813,200 

January      i,  1917,  to  December  31,  1917 11,244,271 

These  figures  display  only  limited  reliance  upon  this 
special  rate.  In  the  Report  of  the  Federal  Reserve  Board 
for  19 1 5  we  read  the  following:' 

The  effect  of  the  commodity  paper  regulation  was  mainly 
anticipatory  and  protective.  The  certain  assurance  that  what- 
ever funds  might  be  necessary  for  the  gradual  and  orderly 
marketing  of  the  cotton  crop  would  be  available  at  moderate 
rates  had  an  immediate  and  stimulating  effect  on  sentiment. 

But  as  the  cotton  market  improved  after  the  fall  of  191 5, 
and  as  general  ease  in  the  money  market  prevailed,  it  no 
longer  seemed  desirable  to  offer  this  special  rate.  Accord- 
ingly, we  read  in  the  Bulletin  for  January,  1918,^  that  it 
was  merged  with  the  general  commercial  rate.  The  prin- 
cipal significance  of  the  special  commodity  rate  appears  to 
the  writer  to  consist  of  its  indication  of  the  friendly  atti- 
tude of  the  reserve  administration  toward  the  credit  needs 
of  agriculture. 

Let  us  now  consider  the  matter  of  the  rate  of  rediscount 
on  six-months  agricultural  paper  with  a  view  of  comparing 
them  with  commercial  paper  rates  of  lesser  maturity.  On 
account  of  the  many  different  rates,  and  the  changes  in  the 
basis  of  classification  from  time  to  time,  as  well  as  the  fact 
that  differences  existed  between  the  rates  of  the  various 
reserve  banks,  it  would  be  onerous  to  endeavor  to  state 
these  results  in  tabular  numerical  form.  But  the  follow- 
ing observ^ations  may  be  made : 

*  Figures  obtained  from  the  Annual  Report  of  the  Federal  Reserve  Board. 
'Page  8. 
3  Page  30. 


AGRICULTURAL  CREDIT  147 

1.  From  November  16,  1914,  to  January  i,  1915,  the 
six-months  rate  exceeded  the  rates  on  shorter  maturities 
never  by  more  than  one  half  of  one  per  cent.  In  many 
districts  there  was  no  differentiation  on  the  basis  of 
maturities. 

2.  On  January  i,  1916,  the  average  rate  in  the  twelve 
districts  on  agricultural  and  live-stock  paper  maturing 
after  ninety  days  was  five  per  cent.  The  corresponding 
average  for  the  twelve  reserve  banks  on  61-90-day  paper 
was  4  1/6  per  cent. 

3.  On  January  i,  1917,  the  average  rate  on  agricultural 
and  live-stock  paper  maturing  after  ninety  days  was  4  7/8 
per  cent;  61-90-day  paper  averaged  4.2  plus  per  cent. 

4.  On  January  i,  1918,  the  average  rate  on  6-months 
paper  was  5.1  per  cent.  Corresponding  average  on  61-90- 
day  paper  was  4  5/8  per  cent. 

5.  On  January  i,  1919,  the  average  rate  on  6-months 
agricultural  paper  was  5.27  per  cent.  The  corresponding 
average  on  61-90-day  paper  was  4.79  per  cent. 

6.  On  January  i,  1920,  the  average  rate  on  commercial 
and  industrial  paper  maturing  within  ninety  days  was  4.79 
per  cent.  The  rate  on  6-months  paper  was  51/8  per  cent. 

7.  October  31,  192 1,  the  average  rate  on  ninety -day 
plus  paper  was  5  2/3  per  cent.  Corresponding  rate  on  90- 
day  paper  was  the  same. 

8.  At  no  time  has  agricultural  paper  been  discriminated 
against  as  such.  The  only  discrimination  has  been  that 
due  to  the  length  of  the  maturity.  Agricultural  paper 
maturing  within  ninety  days  has  been  discounted  at  the 
same  rates  as  other  commercial  paper.  Part  of  this  period, 
a  preferentially  low  rate  of  discount  was  available  to  the 
member  bank  offering  a  certain  type  of  commodity  paper. 
There  has  been  displayed  ncj  hostility  ai^ainst  the  agricul- 
tural interests  in  the  Reserve  Board's  rate  policy. 


148  FEDERAL  RESERVE  POLICY 

With  this  conclusion  reached  regarding  rates,  it  becomes 
difficult  to  convict  the  Federal  Reserve  Board  of  any  fail- 
ure to  recognize  the  legitimate  needs  of  agriculture.  Ir? 
many  cases  it  has  been  shown  that  the  definition  of  eligible 
agricultural  paper  has  possibly  been  something  more  than 
fair.  Bureaucratic  methods  of  identification  and  certifica- 
tion have  been  conspicuous  by  their  absence.  At  one 
period,  agriculture,  by  means  of  the  special  commodity 
rate,  was  given  a  special  low  rate  under  conditions  whereby 
a  maximum  rate  was  fixed  for  member  bank  charges. 
Liberality  was  displayed  finally  by  the  Reserve  Board  in 
determining  the  percentage  of  each  reserv^e  bank's  resources 
which  might  be  invested  in  member  bank's  six-months 
agricultural  or  live-stock  paper.  Unfairness  to  agriculture 
must,  if  it  existed  at  all,  have  occurred  by  means  of  direct 
methods  employed  by  the  district  directorates.  By  direct 
methods  we  refer  to  the  refusals  of  these  directorates  to 
accept  for  discount  or  purchase  good  eligible  paper  from 
the  member  banks.  Let  us  next  ascertain,  so  far  as  is  possi- 
ble, the  extent  to  which  agriculture  may  have  encountered 
hostility  in  this  manner.  ^ 

The  period  in  which  to  search  for  this  hostile  discrimina- 
tion must  be  that  of  1 921 -21,  the  years  of  deflation  in 
agricultural  prices.  Nobody  accused  the  reserve  manage- 
ment of  illiberality  in  the  earlier  years.  Until  the  war 
period  the  chief  concern  of  the  reserve  management  seems 
to  have  been  to  secure  more  complete  employment  fof 
reserve  funds.  During  the  war  period  and  for  a  year  fol* 
lowing  the  armistice,  credit  expansion  proceeded  at  an 
unexampled  rate.  What,  then,  does  the  evidence  show 
regarding  the  relative  treatment  of  agriculture  and  other 
industry  in  the  years  1920-21? 

In  the  Bulletin  for  August,  192 1,'  Governor  Harding,  of 

'  Pages  895-99. 


AGRICULTURAL  CREDIT  149 

the  Reserve  Board,  in  a  letter  to  Senator  Owen  gives  cer- 
tain figures  bearing  upon  this  matter.  Some  of  these  may 
be  quoted: 

On  July  9,  1920,  the  total  bills  on  hand  at  all  Federal  reserve 
banks  amounted  to  $2,934,184,000.  On  July  6,  192 1,  this  total 
amounted  to  $1,832,499,000,  a  decrease  of  $1,101,685,000.  .  .  . 
The  total  of  agricultural,  commercial,  and  live-stock  paper  on 
hand,  rediscounted  for  member  banks,  on  July  6,  192 1,  was 
$1,126,968,000  as  against  a  total  of  $1,265,243,000  on  July  9, 
1920,  a  decrease  of  only  $138,257,000,  which  is  more  than 
accounted  for  by  the  decrease  in  the  holdings  of  paper  of  this 
kind  by  the  Federal  Reserve  Banks  of  Boston,  New  York,  and 
Chicago. 

In  other  words, 

The  bank  liquidation  which  has  taken  place  has  been  mainly 
in  financial  and  industrial  centers,  and  the  figures  do  not  indi- 
cate that  there  has  during  the  past  12  months  been  any  decrease 
in  Federal  Reserve  accommodations  to  banks  in  the  agricultural 
and  live-stock  districts,  but  on  the  contrary  there  has  been  a 
considerable  increase. 

Similar  figures  chosen  for  other  dates  of  1920-21  point 
toward  the  same  general  conclusion. 

But  such  figures  as  these  do  not  tell  the  whole  story.  As 
prices  decline,  the  need  for  credit  to  accomplish  the  same 
volume  of  business  recedes  also.  In  the  depression  of  busi- 
ness in  1920-21,  the  decline  in  agricultural  prices  pro- 
ceeded much  faster  than  the  reduction  of  credits.  Since  in 
the  nine  agricultural  districts  there  was  no  decline  in  hold- 
ings of  agricultural  paper,  it  would  appear  as  if  in  relation 
to  the  state  of  prices  reserve  funds  were  being  enlarged 
consideral)ly  for  the  benefit  of  agriculture.  The  fall  in  the 
prices  of  wholesale  agricultural  products  for  this  period  is 
indicated  by  the  following  group  index  numbers  supplied 
by  the  United  States  Bureau  of  Labor  Statistics: ' 

'  Commodities  have  liecn  regroiipe<l  by  the  Federal  Rescr\'c  lioard  and  tlic 
index  nunibers  are  published  monthly  in  the  BidkUn. 


150  FEDERAL  RESERVE  POLICY 


1913  = 

=  100 

192c 

) 

1921 

June 

=  301 

January      =  155 

July 

=  287 

February    =  145 

August 

=  259 

March         =  136 

September 

=  232 

April            =  126 

October 

=  191 

May            =131 

November 

=  170 

June            = 125 

December 

=  155 

July            =122 
August        =  123 

These  facts  do  not  answer  the  question  as  to  the  treat- 
ment of  the  farming  class  accorded  by  the  member  banks 
themselves.  But  it  should  be  remembered  that  the  reserve 
manangement  has  no  direct  control  over  member  banks' 
discount  policy.  So  far  as  its  operations  are  concerned,  the 
reserve  system  appears  to  have  displayed  every  desire  to 
lessen  the  shock  of  the  liquidation  of  1920-21. 

It  may  be  true  also  that  the  reserve  management's 
general  rediscount  policy  preceding  the  depression  of  1920- 
21  is  to  be  condemned.  However  this  may  be,  it  will  later 
be  shown  that  ample  warnings  were  given  for  the  rate 
increases  of  the  fall  of  19 19  and  for  1920;  ^  that  these  rate 
increases  were  made  only  when  the  reserves  of  the  reserve 
banks  were  so  low  as  to  necessitate  restrictive  measures. 
Moreover,  the  reserve  banks'  discount  rates  tended  to 
follow  rather  than  to  precede  those  of  the  general  money 
market.  The  causes  of  the  deflation  were  many;  but  fig- 
ures show  that  the  responsibility  of  the  reserve  manage- 
ment, so  far  as  the  volume  of  discounts  is  concerned,  was 
confined  to  checking  the  rate  of  credit  expansion.  There 
had  to  be  a  stop  some  time. 

In  view  of  these  many  evidences  of  exceptional  favors, 
to  be  found  not  merely  in  the  statute,  but  also  in  the  man- 
agement of  the  system,  it  is  interesting  to  attempt  to 

'  See  infra,  Chapters  XV  and  XVI. 


AGRICULTURAL  CREDIT  151 

explain  the  general  discontent  with  the  reserve  system 
manifested  by  the  agricultural  classes  after  the  depression 
of  1920-21.  That  a  genuine  feeling  of  hostility  has  been 
created,  in  the  farming  districts  of  the  Middle  West  and 
South  particularly,  cannot  be  doubted  by  anyone  who  has 
had  the  opportunity  of  coming  into  close  personal  contact 
with  the  farmers  of  these  sections.  The  following  explana- 
tions are  offered: 

First  of  all,  the  farmer  suffered  relatively  the  most  of  all 
classes  by  the  general  price  decline.  Index  figures  for 
wholesale  prices  furnished  by  the  United  States  Depart- 
ment of  Labor's  Bureau  of  Labor  Statistics  show  that 
while  farm  products  fell  from  a  figure  of  287  on  July,  1920 
(1913-100),  to  122  on  July,  1921,  all  commodities  fell  in 
the  same  period  from  262  on  July,  1920,  to  148  on  July, 
1 92 1.  Retail  prices  fell  even  much  more  slowly.  Of  all 
classes  the  farmer  was  probably  more  convinced  than  any 
other  that  the  price  gains  of  the  war  period  would  be  main- 
tained. Encouraged  by  his  political  representatives,  by 
editors  of  agricultural  journals,  by  officers  of  his  organiza- 
tion, he  was  led  to  believe  that  the  old  order  had  changed 
once  for  all.  Instead  of  creating  rainy-day  funds  for  future 
emergencies,  his  profits  of  war-time  were  employed  to 
finance  larger  personal  expenditures  and  the  purchase  of 
new  land  and  more  expensive  equipment.  In  many  local- 
ities of  every  agricultural  State,  land  speculation  forced 
prices  up  to  a  point  where  only  the  most  careful  husbandry 
could  produce  a  fair  return  on  the  inflated  values.  The 
transportation  breakdown  and  high  freight  rates  contrib- 
uted to  the  decline  in  farm-products  values.  In  all  this 
the  local  banker  was  not  without  blame.  It  was  his  duty 
to  prevent  the  use  of  bank  funds  for  excessive  speculation. 
In  the  localities  where  he  failed  most  to  assume  this 
obligation,  recovery  from  the  depression  was  most  difficult. 


152  FEDERAL  RESERVE  POLICY 

When  pressed  for  credit  he  did  not  feel  able  to  grant,  the 
local  banker  frequently  found  it  possible  to  throw  respon- 
sibility upon  the  reserve  management.  The  local  banker 
pointed  to  the  increased  rediscount  rates  exacted  by  the 
district  bank,  and  to  warnings  of  the  district  directorate. 
The  district  bank  could  refer  to  the  warnings  and  admoni- 
tions of  the  Federal  Reserve  Board.  Political  representa- 
tives in  Congress,  often  without  any  real  understanding 
of  the  nature  of  the  reserve  system,  added  to  the  pressure 
brought  to  bear  against  the  Board.  It  was  a  grand  old 
game  of  "passing  the  buck."  In  all  this  the  emergency 
character  of  the  reserve  system  was  forgotten,  as  also  the 
exceptional  character  of  the  war  period.  It  was  assumed 
that  the  reserve  system  was  obligated  to  furnish  funds  for 
private  profit-making  purposes.  To  the  writer  it  seems 
unfortunate  that  this  turn  of  affairs  was  not  anticipated 
earlier.  The  mistake  of  the  reserve  management  (a  mis- 
take, however.  Treasury  policy  made  it  difficult  to  avoid) 
lay  in  permitting  the  expansion  of  the  post-war  period,  not 
in  checking  it  when  it  appeared  about  to  pass  all  bounds  of 
safety. 

There  were  also  current  many  misconceptions  as  to  the 
nature  of  the  reserve  system.  As  previously  indicated,  the 
regional  character  of  the  system  often  was  overlooked.  It 
was  forgotten  that  the  reserve  bank  in  Kansas  City  is  a 
different  bank  from  that  of  New  York.  It  serves  a  different 
set  of  industries  and  interests,  and  is  managed  by  directors 
selected  by  a  different  group  of  men.  The  fact  that  credits 
are  made  available  in  one  district  for  purposes  denied  in 
another  does  not  necessarily  indicate  sectional  partiality. 
It  may  mean  solely  that  one  reserve  bank  was  previously 
more  careful  in  its  credit  grants,  and  had  built  up  a  greater 
reserve  to  support  new  financing. 

It  may  have  been    unfortunate   that  in  the  financial 


AGRICULTURAL  CREDIT  153 

centers  security  speculation  could  not  have  been  subjected 
to  more  strict  control.  But  our  methods  of  war  finance 
rendered  this  control  difficult.  We  floated  our  bond  issues 
at  cheap  rates  by  placing  the  resources  of  the  reserve  banks 
at  the  beck  and  call  of  member  banks.  Until  the  war-paper 
holdings  of  member  banks  were  reduced  it  was  difficult  to 
render  effective  a  policy  of  credit  restraint.  Finally  the 
credit  situation  got  out  of  hand.  A  check  in  the  rate  of 
increased  grants  of  reserve  funds  was  inevitable.  Many 
mistakes  were  doubtless  made  in  all  this.  But  they  were 
not  mistakes  of  attempted  and  purposed  discrimination 
against  the  agricultural  borrowers. 

Finally,  the  farming  class,  as  also  others,  has  failed 
often  to  perceive  the  real  character  of  the  sort  of  opera- 
tions permitted  for  the  reserve  banks.  The  reserve  system 
was  intended  to  be  an  institution  dealing,  with  a  few  ex- 
ceptions, in  paper  of  a  commercial  character.  Its  reserves 
are  the  country's  final  and  ultimate.  They  must  be  kept 
liquid.  It  never  was  contemplated  that  the  reserve  system 
should  supply  funds  through  the  discount  of  paper  arising 
in  land  or  commodity  speculation  or  for  long-time  develop- 
mental purposes.  It  may  be  legitimate  for  credits  of  this 
sort  to  be  supplied  by  such  institutions  as'^the  War  Finance 
Corporation  or  the  Federal  Farm  Loan  Banks.  The  writer 
would  be  one  of  the  first  to  admit  the  necessity  of  develop- 
ing institutions  for  the  sake  of  procuring  for  the  farmer  the 
funds  of  the  saving  and  investing  classes.  But  reserve 
funds  are  intended  for  other  purposes.  The  reserve  system 
is  a  set  of  regional  banks  designed  to  guarantee  the  liquid- 
ity of  sound  paper  of  commercial  banks. 


CHAPTER  VIII 
THE  DEVELOPMENT  OF  THE  BANK  ACCEPTANCE 

JN  a  previous  chapter  mention  was  made  of  the  impor- 
tance generally  ascribed  to  the  work  of  popularizing  the 
trade  acceptance.  Among  the  anticipated  advantages  was 
the  devising  of  a  type  of  paper  which  should  command  a 
broad  and  steady  market  and  therefore  comprise  a  suit- 
able investment  for  commercial  banks.  But  in  this  respect 
the  development  of  the  bank  acceptance  deserves  even 
greater  mention.  It  would  seem  that  no  paper  could  be 
more  liquid  in  open-market  transactions  than  that  ac- 
cepted by  an  institution  with  the  financial  status  of  a  bank. 
The  essential  function  of  the  bank  acceptance  is  to  sub- 
stitute for  the  inferior  credit  of  the  individual  the  more 
easily  liquidated  obligation  of  a  bank.  Because  of  the  wide 
market  for  the  bank  acceptance,  the  bank  may  be  able  to 
meet  the  needs  of  its  customer  even  though  it  itself  is 
unable  or  non-desirous  of  making  a  straight  loan.  Instead 
of  discounting  its  customer's  note  and  furnishing  the  funds 
itself,  the  bank  merely  assists  its  customers  to  obtain  the 
advance  from  some  other  institution.  By  accepting  this 
draft  the  bank  places  the  customer  in  possession  of  paper 
which  may  be  sold  to  some  other  banking  institution.  The 
accepting  bank  assumes  no  responsibility  until  the  date  of 
the  maturity  of  the  draft.  But  on  or  before  the  date  when 
payment  becomes  due,  the  customer  is  expected  to  pro- 
vide funds  for  the  meeting  of  the  draft.  This  may  have 
been  accomplished  previously  by  the  opening  of  a  credit  in 
favor  of  the  individual,  or  by  turning  over  to  the  bank  for 


DEVELOPMENT  OF  BANK  ACCEPTANCE   155 

collection  customers'  paper  maturing:  at  approximately  the 
same  date  as  the  bank  acceptance  and  aggregating  perhaps 
a  substantially  equivalent  amount. 

In  the  import  trade  past  events  had  shown  the  necessity 
of  the  development  of  the  acceptance  method.  When  the 
seller  of  the  goods  resides  in  a  foreign  country,  it  is  pecu- 
liarly desirable  that  the  importer's  bank  be  permitted  to 
accept  the  draft.  The  standing  of  the  importer  may  not  be 
sufficient  to  enable  him,  by  means  of  his  own  acceptance, 
to  add  much  strength  to  the  bill  drawn  by  the  foreign  ex- 
porter. Prior  to  191 3  acceptance  powers  were  not  con- 
ferred by  law  upon  national  banks.  Accordingly,  when 
occasions  arose  which  necessitated  the  substittition  of  a 
bank  for  the  American  importer  as  acceptor,  reliance 
might  have  to  be  placed  upon  some  foreign  banking  insti- 
tution. This  could  be  accomplished  by  the  American 
bank's  issuance  to  its  customer  of  a  letter  of  credit  ad- 
dressed to  some  London  institution  requesting  that  it 
accept  the  bill.  Arrangements  would  be  made  whereby  the 
London  institution  would  be  supplied  with  funds  to  meet, 
on  maturity,  any  draft  drawn  under  the  letter  of  credit. 

In  several  ways  this  financing  through  London  was  not 
thoroughly  satisfactory  to  American  trade  and  banking 
interests.  In  the  first  place,  this  method  virtually  required 
the  American  firm  to  pay  two  commissions,  the  one  repre- 
senting compensation  for  the  service  of  the  America^ 
institution  in  issuing  the  letter  of  credit,  the  other  compen« 
sation  for  the  London  bank  in  honoring  it.  The  entire 
service  could  have  been  rendered  by  the  American  institu- 
tion had  legal  authority  for  the  acceptance  existed.  In  the 
aggregate  the  yearly  charges  upon  American  industry 
which  went  to  swell  the  revenues  of  London  institutions 
were  very  great.  London  was  securing  business  which 
might  have  been  performed  by  our  own  banks. 


156  FEDERAL  RESERVE  POLICY 

Reliance  upon  London  increased  the  difficulty,  more- 
over, of  developing  the  use  of  the  dollar  exchange  in  inter- 
national transactions.  Drafts  drawn  against  English 
houses  must  necessarily  be  couched  most  frequently  in 
terms  of  sterling.  When  the  time  arrived  for  furnishing 
"cover,"  the  American  firm  would  be  obliged  to  provide 
whatever  sum  in  dollars  the  prevailing  quotations  on 
sterling  would  make  necessary.  The  risks  of  exchange 
fluctuations  were  borne  by  American  trading  interests. 

In  the  endeavor  to  avoid  this  loss  by  exchange,  the 
American  firm  might  make  forward  contracts  for  the 
amount  of  sterling  credits  necessary  for  cover.  But  this 
only  meant  that  the  risk  in  exchange  was  placed  on 
the  shoulders  of  another  party.  The  assumption  of  this  risk 
was  a  service  demanding  compensation.  Payment  for  it 
represented  an  increase  burden  upon  American  trade. 

In  the  financing  of  the  export  trade  a  similar  necessity 
existed  for  the  bank  acceptance.  Let  us  suppose  that  an 
exporter  in  New  York  ships  goods  to  a  buyer  in  Buenos 
Aires.  Immediately  he  draws  a  draft  upon  the  buyer  and 
attaches  thereto  the  shipping  documents  covering  the 
goods  sold.  In  case  the  shipper's  bank  is  in  position  to  dis- 
count the  draft,  no  difficulty  would  arise  in  the  financing 
of  the  transaction.  The  seller  secures  his  funds  at  once, 
and  is  liable  only  in  case  of  the  inability  of  the  bank  to 
collect  from  the  purchaser  in  Buenos  Aires. 

In  many  situations,  however,  the  ability  of  the  bank  to 
discount  these  bills  would  be  limited.  The  bills  ran  cus- 
tomarily for  a  long  period  of  time.  Relatively  speaking, 
South  American  countries  have  been  capital-poor  coun- 
tries. They  must  buy  largely  on  time.  Their  industries, 
moreover,  are  dependent  largely  upon  agriculture.  In 
years  of  poor  crops  or  of  a  depressed  foreign  market  abroad 
for  their  agricultural  produce,  the  period  of  liquidation  is 


DEVELOPMENT  OF  BANK  ACCEPTANCE   157 

prolonged.  Frequent  renewals  become  necessary.  Under 
these  conditions  the  American  bank  might  feel  obliged  to 
refuse  a  straight  discount. 

By  means  of  the  acceptance,  however,  the  bank  may  be 
able  to  aid  the  seller  to  secure  the  funds  immediately  in  the 
open  market.  The  exporter  draws  another  draft  against 
his  bank,  which  accepts  it  under  condition  that  the  trade 
draft  will  be  turned  over  to  it  for  collection,  the  proceeds 
to  be  employed  to  cancel  the  acceptance  credit.  The  bank, 
either  directly  or  through  some  other  American  house, 
forwards  the  trade  draft  with  the  shipping  document  to  a 
Buenos  Aires  correspondent.  When  the  buyer  accepts  the 
draft  he  receives  the  shipping  documents.  By  this  method 
the  American  seller  is  given  negotiable  paper,  which  can 
be  discounted  in  the  general  market  because  of  the  strength 
given  by  the  bank's  acceptance. 

Not  only  was  it  argued  that  bank  acceptance  would 
enable  the  exporter  to  secure  his  funds  quickly,  but  it  was 
also  anticipated  that  it  would  offer  a  means  whereby  the 
financing  of  foreign  trade  could  be  deflected  from  New 
York  to  London  as  money  market  conditions  might  neces- 
sitate. Regarding  this  point  we  read  in  the  Bulletin  for 
May  I,  1915:' 

The  importance  of  the  development  of  this  banking  instru- 
ment is  now  beginning  to  be  generally  understood,  and  inquiries 
which  have  been  made  indicate  that  additional  banks  are  pre- 
paring to  offer  accepting  facilities  to  their  customers.  From 
the  point  of  view  of  the  development  of  a  stable  market  in  New 
York  City  for  dollar  acceptances,  this  is  of  importance,  for  such 
a  market  depends  primarily  upon  a  large,  steady  volume  and 
low,  steady  rates.  Several  banks  and  firms  dealing  in  bills  have 
also,  largely  within  the  present  month,  begun  to  quote  forward 
rates  on  bills  drawn  in  dollars,  so  that  exporters  in  distant 
countries  may  be  able  to  calculate  the  comparative  negotiable 

'  Page  53. 


158  FEDERAL  RESERVE  POLICY 

value  of  sterling  and  dollar  drafts.  This  is  also  of  fundamental 
importance  in  the  development  of  the  acceptance  business. 
When  the  movement  of  our  exports  and  imports  has  been  sufifi- 
ciently  standardized  through  b.uikers'  acceptances,  so  that  it 
may  be  facilitated  as  easily  in  the  New  York  as  in  the  London 
market,  even  though  the  volume  in  the  New  York  market  may 
be  much  smaller,  we  should  be  enabled  readily  in  the  future, 
when  we  wish  to  protect  our  reserves  or  when  they  are  needed 
for  domestic  expansion  or  seasonal  movements  of  commodities, 
to  deflect  the  financing  of  our  foreign  trade  from  New  York  to 
London  by  raising  New  York  rates  above  London  rates  and 
making  it  cheaper  for  the  shipper  to  draw  on  London  than  on 
New  York.  Conversely,  when  we  are  ready  to  finance  it  again 
we  should  be  able,  in  normal  times,  to  recover  the  business  from 
London  by  reducing  our  rates  below  those  of  London.  At  other 
times,  of  course,  London  may  take  the  initiative  in  readjusting 
the  rates  for  one  or  another  of  these  purposes,  just  as  its  rates 
have  been  raised  substantially  during  the  past  30  days  as  a 
protection  to  its  reserves. 

In  general  the  bank  acceptance  was  regarded  as  necessary 
in  order  that  our  financial  centers  might  assume,  in  the 
field  of  international  finance,  the  place  commensurate  with 
the  importance  of  American  trade  and  industry. 

Most  of  the  above  considerations  were  stressed  also  in 
discussions  relating  to  the  financing  of  domestic  trade. 
Aside  from  the  fact  that  foreign  trade  involves  the  trans- 
lation of  the  medium  of  exchange  of  one  country  into  that 
of  another,  distant  domestic  transactions  offer  the  same 
problems  as  foreign.  It  is  still  necessary  to  find  a  means  of 
substituting  bank  time-credit  for  the  credit  of  the  indi- 
vidual. But  the  points  emphasized  rruDst  largely  in  the  days 
of  banking-reform  discussion  were  the  aid  which  the  ac- 
ceptance might  render;  first,  in  the  campaign  to  create  a 
broad  and  steady  market  for  commercial  paper ;  and  second, 
in  the  equalization  in  some  degree  of  money  rates  in  dif- 
ferent sections  of  the  country. 


DEVELOPMENT  OF  BANK  ACCEPTANCE   159 

In  rejrarcl  to  the  first  matter  it  was  argued  that  the  hank 
acceptance  would  do  much  to  standardize  the  commercial 
paper  available  for  bank  investments.  The  credit  of 
individuals  varies  in  quality,  but  paper  representing  the 
obligations  of  banks  should  possess  some  degree  of  uni- 
formity. The  bank  acceptance  offered  a  means  of  substi- 
tuting the  one  type  of  paper  for  the  other.  If  commercial 
paper  could  be  thus  standardized,  much  would  be  accom- 
plished in  the  way  of  relieving  the  stock  market  from  the 
uncertainties  of  the  call-loan  market.  As  an  element  in 
banks'  secondary  reserves  it  was  anticipated  that  the 
acceptance  might  become  the  most  important  item.  It  was 
argued  that  this  would  constitute  an  advantage  for  the 
security  investment  as  well  as  for  the  banking  interests. 
Stocks  and  bonds  of  fluctuating  value  should  be  financed 
by  time  loans.  In  no  other  way  can  they  be  relieved  on 
intimate  dependence  upon  momentary  changes  in  money 
rates. 

As  a  second  advantage,  it  was  urged  that  the  acceptance 
would  assist  in  the  transfer  of  banking  funds  from  the  capi- 
tal-poor to  the  capital-rich  sections  of  the  country.  Pre- 
viously, such  a  redistribution  in  the  employment  of  bank 
funds  was  made  difficult  because  of  the  inferiority  of  pri- 
vate credit  in  the  borrowing  sections.  The  acceptance 
offered  a  means  of  overcoming  this  difficulty  to  some  extent 
in  short-time  transactions.  Eastern  banks  would  be 
expected  to  show  more  willingness  to  purchase  paper 
accepted  by  a  Western  bank  than  that  of  a  pri\atc 
individual. 

Under  the  terms  of  the  banking  laws  of  some  States 
recognition  of  the  merit  of  the  acceptance  had  been  made 
prior  to  the  passage  of  the  Federal  Reserve  Act.  In  the 
Report  of  the  Board  for  the  year  191 9  we  read :  * 

'Page  21. 


i6o  FEDERAL  RESERVE  POLICY 

Incorporated  banks  were  first  permitted  to  accept  about  lo 
years  ago  under  the  laws  of  some  of  the  States  in  which  they 
were  domiciled. 

It  is  by  the  terms  of  the  act,  however,  that  national  banks 
are  first  endowed  with  acceptance  powers.  According  to 
the  terms  of  the  original  statute  member  banks  were  given 
the  right  to* 

accept  drafts  or  bills  of  exchange  drawn  upon  it  and  growing 
out  of  transactions  involving  the  importation  or  exportation 
of  goods  having  not  more  than  six  months'  sight  to  run. 

In  view  of  the  arguments  previously  advanced  in  behalf 
of  the  use  of  the  acceptance  in  domestic  trade,  it  may  seem 
strange  to  note  that  the  original  act  confined  its  use  to 
foreign-commerce  transactions.  Explanation  for  this  fact, 
however,  is  not  dif^cult  to  find.  In  the  first  place,  it  was  not 
desired  that  in  the  beginning  the  bank-acceptance  method 
should  be  pushed  among  all  sorts  of  institutions.  It  was 
hoped  that  its  use  might  be  confined  to  banks  of  the  high- 
est degree  of  solvency.  As  a  rule  institutions  which  had 
been  prominent  in  foreign-trade  financing  were  classified 
among  those  of  highest  solvency. 

In  the  second  place,  it  was  perceived  that  the  foreign 
trade  acceptance  was  necessary  in  order  to  encourage  the 
use  of  the  dollar  exchange.  As  long  as  London  banks 
accepted  for  international  trade  purposes,  the  banker's 
bill,  in  the  great  majority  of  cases,  would  be  drawn  in 
terms  of  sterling  money.  This  was  a  matter  which  involved 
rivalry  with  a  foreign  banking  mart;  it  seemed  especially 
important  that  restrictions  preventing  our  banking  institu- 
tions from  competing  on  even  terms  with  the  foreign  should 
be  removed. 

Finally,  the  inflationary  possibilities  of  the  bank  ac- 

» Section  13. 


DEVELOPMENT  OF  BANK  ACCEPTANCE   i6i 

ceptance  were  recognized.  As  indicated  previously  the 
acceptance  method  offers  a  means  whereby  local  indus- 
tries may  be  permitted  to  draw  upon  surplus  funds  in  the 
outside  banking  community.  There  was  danger  that  credits 
should  be  offered  too  liberally;  credits  not  merely  in  the 
aggregate,  but  also  in  the  amount  extended  to  a  single  firm. 
Accordingly,  the  original  act  confined  its  use  to  one  single 
type  of  transactions. 

Subsequently,^  however,  the  act  was  amended  to  permit 
of  its  employment  in  other  types  of  transactions.  These 
were  :  first,  for  the  purpose  of  creating  dollar  exchange; 
secondly,  to  finance  the  domestic  shipments  of  goods; 
thirdly,  to  permit  the  temporary  storage  of  staples  pend- 
ing a  reasonably  prompt  sale  or  distribution. 

The  reader  of  section  13  may  be  somewhat  confused  by 
the  very  many  restrictions  confining  the  use  of  the  bank 
acceptance.  Some  of  these  restrictions  were  a  part  of  the 
original  act;  others  were  introduced  in  subsequent  amend- 
ments. It  may  be  desirable,  therefore,  to  inquire  as  to  the 
motives  of  the  lawmakers  in  inserting  these  restrictions  in 
the  statute.  Aside  from  matters  previously  mentioned  — 
the  desire  to  preserve  for  the  acceptance  a  distinctive 
place  as  a  superior  type  of  commercial  paper  available  for 
member  banks'  secondary  reserves,  and  the  fear  of  its 
inflationary  possibilities  —  the  following  explanations 
may  be  ventured.  First,  it  was  made  available  for  redis- 
count or  purchase  by  reserve  banks  at  a  specially  low  rate. 
For  a  considerable  period  after  the  acceptance  regulations 
were  issued  by  the  Board,  the  rates  on  such  rediscounts 
were  announced  as  varying  between  two  and  four  per  cent. 
The  minimum  figure  was  considerably  less  than  the  average 
rate  on  other  paper.  A  consideration  determining  whelhcr 
the  rate  would  correspond  more  closely  with  the  maximum 

'  By  the  amending  act  of  September  7,  1916. 


i62  FEDERAL  RESERVE  POLICY 

or  minimum  would  be  the  standing  of  the  firm  actinj^  as 
acceptor.  A  higher  rate  would  be  a  means  of  discouraging 
the  offer  of  undesired  acceptances.  As  stated  by  the  Board 
in  an  Informal  Ruling  in  the  November  i,  191 5,  Bulletin:  ^ 

It  is,  of  course,  understood  that  the  Board  would  not  wish  to 
see  concerns  regarded  as  eligible  acceptors  which  are  not  in 
the  habit  of  carrying  on  some  acceptance  business  regularly 
and  are  not  generally  of  such  character  and  standing  as  to  qual- 
ify their  acceptance  as  a  banker's  acceptance. 

As  in  the  case  of  the  trade  acceptance,  it  was  to  be  expected 
that  many  illegitimate  attempts  would  be  made  to  gain  the 
advantage  of  the  low  rates. 

As  a  second  explanation,  it  was  to  be  expected  that  the 
bank  acceptance  as  a  superior  type  of  commercial  paper 
would  come  to  occupy  a  prominent  place  in  the  portfolios 
of  reserve  banks.  In  the  early  days  of  operation  the  sup- 
port of  the  reserve  banks  would  be  necessary  In  order  to 
encourage  Its  use.  Later,  large  amounts  of  acceptances 
would  be  purchased  by  reserve  banks  as  a  part  of  their 
open-market  operations.  It  was  emphatically  necessary 
that  the  reserve  banks  keep  their  assets  In  liquid  shape. 
Precautions  were  felt  to  be  peculiarly  necessary  in  order  to 
prevent  an  unduly  rapid  growth  of  such  paper. 

Finally,  with  certain  exceptions,  the  limitations  of  sec- 
tion 5200  would  not  apply  to  the  bank  acceptance.  The 
theory  justifying  this  exception  is  that  an  acceptance  Is  not 
a  loan  of  money.  The  accepting  bank  merely  lends  Its 
credit  to  the  maker  of  the  bill.  The  bank's  responsibility 
is  contingent  only  and  not  direct.  Because  of  the  remote- 
ness of  loss  under  this  contingent  guarantee,  it  was  not 
esteemed  necessary  to  provide  for  the  application  of  the 
same  laws  which  govern  the  straight  loan.   Accordingly, 

'  Page  36. 


DEVELOPMENT  OF  BANK  ACCEI^ANCE      163 

by  the  amendment  of  September  7,  191 6,  a  sentence  in 
section  13  was  made  to  read : 

No  member  bank  shall  accept,  whether  in  a  foreign  or  domes- 
tic transaction,  for  any  one  person,  company,  firm,  or  corpora- 
tion to  an  amount  equal  at  any  time  in  the  aggregate  to  more 
than  ten  per  centum  of  its  paid-up  and  unimpaired  capital  stock 
and  surplus,  unless  the  bank  is  secured  either  by  attached 
documents  or  by  some  other  actual  security  growing  out  of  the 
same  transaction  as  the  acceptance. 

This  was  a  negative  way  of  providing  that  acceptances 
thus  secured  might  be  made  to  an  amount  exceeding  ten 
per  cent  of  the  capital  and  surplus.  But  if  not  secured,  the 
liability  of  the  bank,  contingent  though  it  be,  was  con- 
sidered too  great.  If  law  established  for  the  acceptance 
no  such  limitation  as  section  5200  provided  for  the  straight 
loan,  all  the  greater  appeared  the  necessity  of  imposing 
other  restrictions. 

While  discussing  this  matter  intrepretation  should  be 
made  of  the  phrase,  "attached  documents  or  by  some 
other  actual  security."  It  is  evident  that  the  documents 
must  be  surrendered  to  the  purchaser  before  the  latter 
can  obtain  the  goods,  and  that  after  their  surrender  the 
documents  are  not  in  the  possession  of  the  bank.  To  cover 
this  situation  the  following  ruling  was  announced  by  the 
Board  in  the  February,  1919,  Bulletin:  ^ 

It  [a  member  bank]  cannot  accept  in  domestic  transactions 
without  being  secured  at  the  time  of  acceptance,  but  may  re- 
lease the  security  after  acceptance  upon  the  execution  of  a  trust 
receipt  or  an  agreement  by  the  customer  that  so  much  of  the 
proceeds  of  the  sale  of  the  goods  covered  by  the  security  as  may 
be  necessary  to  pay  the  draft  will  be  deposited  with  the  accept- 
ing hank  when  available  and  will  not  be  used  for  other  [)urposcs. 

Under  certain  conditions,  however,  an  acceptance  would 

«  Page  143. 


i64  FEDERAL  RESERVE  POLICY 

become  for  all  practical  purposes  a  loan  or  a  discount. 
Lender  such  conditions  section  5200  would  apply.  One  of 
these  situations  would  be  that  in  which  the  accepting  bank 
some  time  subsequent  to  acceptance  purchases  its  own 
acceptance. 

This  practice,  the  purchase  by  the  bank  of  its  own 
acceptance,  was  not  welcomed  as  customary  procedure.  An 
acceptance  is  a  means  whereby  some  other  bank  is  to  fur- 
nish the  funds.  On  certain  occasions,  however,  such  action 
might  prove  necessary.  If  no  outside  demand  for  the 
acceptance  occurred,  the  only  means  of  protecting  the 
acceptance  market  would  be  for  the  accepting  bank  to  make 
the  purchase.  Such  action  might  be  defended  on  the 
ground  that  the  acceptance  method  must  not  be  permitted 
to  fall  into  disrepute. 

Ordinarily,  however,  such  action  should  not  prove  nec- 
essary. So  desirous  have  the  reserve  authorities  been  that 
the  bank-acceptance  method  should  be  encouraged  for 
legitimate  purposes,  and  so  well  fortified  have  the  reserve 
banks  been  in  their  open-market  powers,  that  the  market 
should  not  customarily  fail  for  prime  acceptance  paper. 
Although  somewhat  handicapped  by  the  slow  develop- 
ment of  special  discount  corporations,  the  acceptance 
demand  has  been  enlarged  recently  on  the  part  of  other 
institutions,  as,  for  instance,  savings  banks.  In  some 
cases,  furthermore,  it  appeared  that  the  purchase  of  the 
bank's  own  acceptance  was  an  attempt  to  evade  the  limi- 
tations of  section  5200  and  find  a  means  of  advancing  more 
to  one  party  than  an  amount  corresponding  to  ten  per 
cent  of  the  bank's  capital  and  surplus. 

By  an  Informal  Ruling,  however,  announcement  was 
made  that  such  practices  could  not  be  permitted  to  accom- 
plish their  purposes,^     It  was  insisted  that  acceptances 

»  Btdletin,  January  I,  1917,  p.  28. 


DEVELOPMENT  OF  BANK  ACCEPTANCE   165 

purchased  by  the  accepting  bank  must  be  considered  as 
loans.  In  such  cases  the  bank's  obligation  is  direct,  and 
not  merely  contingent. 

The  acceptance  method,  furthermore,  contemplated 
that  the  acceptance  credit  would  be  eliminated  by  remit- 
tance of  "cover"  to  the  bank  on  or  before  the  maturity  of 
the  acceptance.  If  the  indebtedness  of  the  drawer  is  not 
destroyed,  the  bank  assumes  the  position  of  making  a 
direct  advance.  Exception  to  this  statement  might  be 
made  only  in  case  the  payee  permitted  the  renewal  of  the 
acceptance.  It  is  not  surprising,  therefore,  to  find  in  the 
Bulletin  for  February,  1916,^  an  Informal  Ruling  to  the 
effect  that 

the  provisions  of  section  5200  of  the  United  States  Revised 
Statutes  would  apply  to  the  indebtedness  arising  between  the 
drawer  of  the  bill  and  the  accepting  bank  in  case  the  drawer 
fails  to  furnish  funds  with  which  to  meet  the  acceptance. 

A  somewhat  confusing  situation  might  arise,  however, 
in  the  case  of  the  rediscount  of  an  acceptance  which  had 
been  purchased  previously  by  the  accepting  bank.  By  the 
act  of  rediscount,  which  transfers  the  paper  to  another 
institution,  the  bank  ceases  to  occupy  the  position  of  a 
lender  of  money.  After  rediscount  its  liability  is  precisely 
the  same  as  that  which  existed  before  the  purchase  of  the 
bill.  The  bank's  obligation  becomes -contingent  only.  Sec- 
tion 5200  does  not  apply. ^ 

We  may  next  consider  the  conditions  governing  the  use 
of  the  acceptance  for  various  classes  of  permitted  pur- 
poses. Let  us  first  turn  our  attention  to  the  use  of  the 
acceptance  in  the  establishment  of  the  dollar  exchange. 
By  the  amendment  of  September  7,  191 6,  member  banks 

'  Page  64. 

'  Cf.  Opinion  of  Counsel,  Bulletin,  Scptcnibcr  i,  1917,  p.  696. 


i66  FEDERAL  RESERVE  POLICY 

were  empowered,  with  the  special  permission  of  the  Fed- 
eral Reserve  Board,  to  accept  drafts 

for  the  purpose  of  furnishing  dollar  exchange  as  required  by  the 
usages  of  trade  in  the  respective  countries,  dependencies,  or 
insular  possessions. 

The  Federal  Reserve  Board  was  given  power  to  determine 
whether  the  country's  trade  usages  were  such  as  to  necessi- 
tate the  acceptance  of  drafts  originating  therein.  In  the 
December  i,  191 6,  Bulletin,^  we  are  informed  that  appli- 
cations had  been  granted  for  the  acceptance  of  drafts 
drawn  in  Porto  Rico,  Santo  Domingo,  Costa  Rica,  Peru, 
Chile,  Brazil,  Venezuela,  Argentina  and  Bolivia.  The 
Board  refused^  to  include  England  or  France  in  this  list. 
The  reason  for  this  discrimination  was  explained  as  follows :  ^ 

The  purpose  of  this  Act  and  the  regulation  made  pursuant 
thereto  was  to  enable  the  American  banks  to  provide  dollar 
exchange  in  countries  where  the  check  is  not  the  current  means 
of  remittance  in  payment  of  foreign  debts,  but  where  the  three 
months'  bankers'  draft  is  generally  used  for  that  purpose.  .  .  . 

The  Board  is  informed  that  the  bankers'  custom  of  selling 
three  months'  drafts  in  preference  to  checks  originated  in  coun- 
tries where  the  mail  connections  were  irregular  and  the  foreign- 
exchange  market  was  a  limited  one,  and  where  it  would  have 
been  difficult  for  the  drawing  banker  to  be  certain  that  he  could 
find  a  cover  against  the  checks  drawn  by  him  in  time  to  forward 
it  by  the  same  mail,  whereas,  in  drawing  a  three  months'  draft, 
he  would  feel  assured  of  being  able  to  forward  remittances 
before  his  obligation  fell  due. 

In  other  words,  irregular  mail  connections  make  it 
impossible  frequently  to  depend  upon  the  immediate 
remittance  of  "cover. "  In  siich  cases,  a  time  bill  is  desired, 
giving  sufficient  opportunity  for  remittance. 

'  Page  665. 

»  Ibid.,  p.  666. 

»  Ihul.,  pp.  665,  666, 


DEVELOPMENT  OF  BANK  ACCEPTANCE   167 

In  a  ruling  by  the  Board  *  it  appears  that  attempts  have 
been  made  to  draw  such  bills  when  the  usages  of  trade 
were  not  such  as  to  require  them.  In  some  countries  where 
the  dollar  was  at  a  premium  such  drafts  would  be  drawn 
to  supply  the  needed  exchange.  The  Board  ruled  that 
these  drafts  could  not  be  accepted  by  American  banks.  It 
appears,  therefore,  that  "the  usages  of  trade"  refers  solely 
to  the  customs  created  because  of  the  lack  of  regular  mail 
connections. 

Statutory  limitations  upon  the  ability  of  banks  to  accept 
such  drafts  were  as  follows:  In  no  case  could  the  amount 
of  acceptances  exceed  one  half  the  capital  and  surplus  of 
the  accepting  bank.  Ten  per  cent  of  the  capital  and  sur- 
plus would  be  the  maximum  unless  "the  draft  or  bill  of 
exchange  is  accompanied  by  documents  convej'Ing  or 
securing  title  or  by  some  other  adequate  security." 

The  second  class  of  bankers'  acceptances  were  those 
arising  out  of  the  importation  or  exportation  of  goods.  In 
absence  of  special  permission  from  the  Board,  member 
banks  are  given  the  right  to  accept  to  an  amount  equal  to 
fifty  per  cent  of  their  capital  and  surplus.  The  Board  is 
empowered ,  however,  to  grant  permission  to  applying  banks 
to  accept  up  to  one  hundred  per  cent  of  the  capital  and 
surplus.  In  pursuance  of  this  power  the  Board  has  regu- 
larly published  the  names  of  banks  which  are  to  be  per- 
mitted to  accept  the  larger  amount. 

The  reason  for  the  insertion  of  such  restrictions  in  the 
statute  is  not  difficult  to  explain.  The  acceptance  is  a 
means  whereby  the  accepting  bank  aids  its  customer  to 
secure  funds  from  the  outside  banking  community. 
Clearly  no  one  bank  should  be  permitted  to  draw  too  heav- 
ily upon  other  banks  for  the  benefit  of  its  own  customers. 
Stating  the  limitation  In  terms  of  a  maximum  and  a  mini- 

'  BuUetin,  August,  1920,  p.  835. 


i68  FEDERAL  RESERVE  POLICY 

mum  gives  the  Board  some  discretion  regarding  the  sort 
of  banks  which  are  to  be  granted  in  greatest  degree  tho 
acceptance  privilege.  In  order  to  ensure  the  acceptance 
against  misuse,  the  Board  has  been  unwilHng  to  encourage 
its  employment  on  the  part  of  firms  whose  standing  is  not 
of  the  highest. 

During  the  foreign-trade  boom  following  the  armistice, 
assertions  were  made  frequently  that  these  limitations 
were  too  severe.  It  may  well  be  that,  in  the  course  of  time, 
a  further  amendment  to  the  statute  will  be  necessary.  But 
in  this  period  the  volume  of  foreign  trade  was  extraor- 
dinarily great.  Under  more  normal  conditions  the  need  of 
the  acceptance  should  not  prove  so  great.  It  may  be 
preferable,  furthermore,  to  extend  its  use  among  a  larger 
number  of  banks  before  granting  greater  powers  to  any  one. 

As  in  the  case  of  the  domestic  acceptance,  member 
banks  may  accept  drafts  which  arise  in  foreign  trade  hav- 
ing a  maturity  of  six  months.  The  maturity  of  a  draft, 
rediscounted  by  a  reserve  bank,  however,  must  not  exceed 
three  months.  It  cannot  be  granted  under  an  agreement 
to  renew.^  The  purpose  of  the  acceptance  was  merely  to 
finance  transactions  capable  of  being  liquidated  in  a  com- 
paratively brief  period.  Funds,  desired  for  longer  pur- 
poses, should  be  obtained  by  means  of  a  straight  loan. 
Since  a  direct  loan  would  be  subject  to  the  restrictions  of 
section  5200,  Revised  Statutes,  agreement  to  renew  an 
acceptance  would  offer  virtually  a  means  of  evading  the 
terms  of  the  statute. 

This  should  not  be  interpreted,  however,  as  denying  a 
member  bank  the  privilege  of  granting  an  acceptance 
credit  outrunning  six  months.  The  acceptance  credit  may 
be  considered  merely  as  permission  to  draw  the  drafts.  The 
limitation  applies  to  the  maturity  of  the  drafts,  not  to  the 

»  C£.  Opinion  of  Counsel,  Bulletin,  March,  1920,  pp.  777-78. 


DEVELOPMENT  OF  BANK  ACCEPTANCE   169 

length  of  the  period  during  which  such  drafts  may  be 
drawn. 

A  problem  of  some  difficulty  had  to  do  with  the  means 
of  identifying  a  foreign-trade  transaction.  How  could  it  be 
distinguished  from  an  operation  of  domestic  trade?  In 
case  the  dealer  handled  only  goods  in  foreign  trade,  the 
presumption  would  be  clearly  in  favor  of  classifying  it  as 
a  foreign-trade  acceptance.  But  if  the  party  handled  goods 
for  the  domestic  as  well  as  for  the  foreign  trade,  it  would 
be  more  difficult  to  determine  to  which  class  it  belonged. 
In  the  latter  case,  accordingly,  it  has  been  ruled  that  the 
dealer  could  be  required  to  display  a  contract  for  foreign 
sale.  It  would  not  be  necessary,  however,  to  identify  in 
the  export  trade  the  specific  goods  placed  on  board  ship.* 

In  the  early  days  of  reserve  operation  it  was  easy  to 
understand  the  necessity  of  distinguishing  between  foreign 
and  domestic-trade  acceptances.  Then,  acceptances  could 
be  given  only  to  finance  transactions  arising  out  of  the 
importation  or  exportation  of  goods.  But  later  amend- 
ments permitted  domestic  acceptances  under  conditions 
substantially  similar  to  foreign.  In  what,  then,  consists 
the  value  of  this  distinction  to-day?  The  answer  consists 
in  part  of  the  provision  that  whereas  member  banks  may 
be  permitted  to  accept  both  classes  of  bills  up  to  an  amount 
equal  to  one  hundred  per  cent  of  their  capital  and  surplus, 
"acceptances  growing  out  of  domestic  transactions  shall 
in  no  event  exceed  fifty  per  cent  of  such  capital  stock  and 
surplus."  To  determine  whether  any  one  bank  is  exceed- 
ing its  acceptance  powers,  it  is  necessary  to  learn  how 
large  are  its  acceptances  for  domestic  and  how  large  for 
foreign-trade  financing. 

The  provisions  of  the  original  act  relating  to  foreign- 
trade  transactions  were  drawn  in  rather  gi-neral  terms.  It 
'  Cf.  Infurma.1  Ruling,  Btdktin,  Dcccmlx:r  i,  1915,  pp.  405-06. 


170  FEDERAL  RESERVE  POLICY 

was  merely  stated  that  the  transaction  must  involve  the 
importation  or  exportation  of  goods.  Would  it  be  suffi- 
cient, then,  if  the  ultimate  object  of  the  transaction  was  to 
supply  goods  for  export? 

The  Opinion  of  Counsel  in  this  matter  is  stated  in  the 
Bulletin  ior  Septcmh(2:r  i,  1915.'  To  quote  the  tennsof  the 
inquiry  stated  therein : 

A  domestic  corporation,  which  for  convenience  will  be  desig- 
nated "Company  A,"  enters  into  a  contract  with  another 
domestic  corporation,  designated  "Company  B,"  to  furnish 
material  to  be  used  by  Company  B  in  the  manufacture  of 
products  which  Company  B  is  under  contract  with  a  foreign 
purchaser  to  export.  Query:  Can  a  national  bank  accept  a 
draft  or  bill  of  exchange  drawn  by  Company  A  and  accompanied 
by  the  necessary  documents? 

It  is  obvious  that  to  hold  such  an  operation  "foreign 
trade"  would  be  to  widen  enormously  the  permitted 
classes  of  acceptance  transactions.  Many  domestic  trans- 
actions result  finally  in  a  foreign  sale.  Many  of  them  fre- 
quently would  be  difificult  to  trace.  It  is  not  surprising, 
therefore,  that  Counsel  ruled  that  the  transaction  itself 
must  involve  a  foreign  sale  or  purchase.  It  is  not  enough 
that  the  domestic  transaction  be  merely  related  to  the 
foreign. 

Let  us  now  turn  out  attention  to  domestic  acceptances. 
The  first  class  of  these  acceptances  permitted  by  the 
statute  are  those  growing  out  of  domestic  shipments  of 
goods  secured  by  the  attachment  of  shipping  documents 
conveying  title  to  the  goods.  In  this  respect  such  domes- 
tic acceptances  stand  on  a  different  basis  from  the  foreign- 
trade  acceptance.  In  the  case  of  the  latter  the  provisions 
of  the  statute  were  intended  merely  to  ensure  the  fact  that 
there  had  been  a  shipment.   Congress  evidently  intended, 

•  Page  276. 


DEVELOPMENT  OF  BANK  ACCEPTANCE      171 

however,  to  restrict  domestic  acceptances  to  a  greater 
extent,  because  it  provided  that  the  shipping  documents 
must  convey  to  the  accepting  bank  title  to  the  goods.  Such 
goods  can  be  released  to  the  purchaser,  however,  on  th(! 
execution  of  a  deed  of  trust  stipulating  that  the  proceeds 
from  the  sale  shall  first  be  devoted  to  the  cancellation  of 
the  acceptance  credit/  The  release  of  the  security  would 
cause,  however,  the  limitations  of  section  5200  to  apply. 
In  that  case  the  bank  is  secured  neither  by  the  attached 
documents  nor  by  the  actual  security  of  the  goods.* 

TheJmore  strict  limitations  upon  domestic  acceptances 
were  due  to  the  possibilities  of  greater  abuses.  The  volume 
of  domestic  transactions  is  much  greater  than  that  of  for- 
eign. Greater  possibilities  of  evil  attach,  therefore,  to  the 
domestic  acceptance. 

The  duration  of  these  acceptances  may  be  as  great  as 
six  months.  But  in  no  case  may  they  run  for  a  period 
longer  than  necessary  to  finance  the  sale.^ 

An  interesting  question  arises  as  to  the  power  to  accept 
when  a  corporation  is  making  a  shipment  of  goods  to  its 
own  agent.  Such  a  transfer  could  not  be  considered  as  a 
sale.  It  would  not  seem  legitimate  to  permit  a  draft  to  be 
accepted  for  any  other  purpose  than  to  finance  the  ship- 
ment, to  offset  temporarily  the  cost  of  transporting  the 
goods.  In  this  case  the  maturity  of  the  draft  should 
approximate  the  duration  of  their  transit.-* 

The  principal  concern  of  the  Board  has  thus  been  to  con- 
fine the  use  of  this  type  of  the  bank  acceptance  to  the 
financing  of  the  shipment  or  the  sale  of  the  goods.  Funds 
desired  to  enable  the  goods  to  be  carried  through  the 
process  of  manufacture  into  finished  products  should  not 

»  Cf.  supra,  pp.  i8a-i8i. 

»  Cf.  Informal  Ruling,  Bulletin,  March,  192 1,  p.  308. 

3  Ibid.,  p.  308. 

*Ci.  Informal  Ruling,  Bulletin,  September  I,  19 17,  p.  69a 


172  FEDERAL  RESERVE  POLICY 

be  financed  by  the  acceptance.  The  acceptance  should  not 
be  employed  to  secure  working  capital.  Funds  for  such 
uses  should  be  obtained  by  the  discount  of  the  borrower's 
promissory  note.  The  acceptance  contemplates  the  ex- 
tinction of  the  credit  from  the  proceeds  of  the  goods 
obtained  by  the  sale  of  the  acceptance. 

The  second  class  of  permitted  domestic  acceptances 
was  those  secured  at  the  time  of  the  acceptance  by  ware- 
house receipts  conveying  title  to  readily  marketable 
goods.  The  function  of  this  acceptance  is  to  assist  the 
producer  in  the  orderly  marketing  of  farm  crops.  If  funds 
could  not  be  obtained  freely  to  hold  the  products  of  the 
farm  in  the  locality  of  their  production  for  a  reasonably 
quick  sale,  the  producer  would  be  more  largely  dependent 
upon  the  offer  of  outside  capital.  The  producer  can  well 
argue  that  means  should  be  found  to  place  him  on  the 
same  basis  as  the  outside  purchaser  with  reference  to  his 
ability  to  obtain  banking  capital.  Banking  capital  may  be 
scarce  in  the  growing  section.  Since  the  security  must 
be  that  of  "readily  marketable  staples"  only,  the  risk  of 
the  bank  which  grants  the  acceptance  credit  should  not 
be  great  ordinarily. 

Such  methods  as  these  could  be  abused  easily  If  no 
limit  were  placed  on  the  period  for  which  the  funds  thus 
obtained  could  be  employed.  By  a  permanent  advance  of 
funds  the  bank  might  be  supplying  capital  for  commodity 
speculation.  Legitimate  use  of  the  acceptance  for  this  pur- 
pose was  thus  stated  by  Counsel  of  the  Board  as  follows: 
The  purpose  must  be 

to  carry  goods  covered  by  warehouse  receipt  pending  a  reason- 
ably immediate  shipment,  a  reasonably  immediate  sale,  or  a 
reasonably  immediate  distribution  into  the  process  of 
manufacture.' 

« Cf.  Opinion  of  Counsel,  Bulletin,  January  i,  1920,  p.  67. 


DEVELOPMENT  OF  BANK  ACCEPTANCE   173 

The  acceptance  must  not  be  made  subject  to  renewals.* 
The  security  may  be  cattle  provided  the  maturity  is  no 
longer  than  that  required  to  fatten  and  resell.^ 

The  use  made  of  this  type  of  the  acceptance  must  depend 
upon  the  definition  of  "readily  marketable  staples."  In 
the  Bulletin  for  July,  1919,^  the  Board  stated: 

A  readily  marketable  staple  may  be  defined  as  an  article  of 
commerce,  agriculture,  or  industry  of  such  uses  as  to  make  it 
the  subject  of  constant  dealings  in  ready  markets  with  such 
frequent  quotations  of  prices  as  to  make  (a)  the  price  "easily 
and  definitely  ascertainable  and  (b)  the  staple  itself  easy  to 
realize  upon  by  sale  at  any  time. 

This  definition  would  bar  the  use  of  the  acceptance  for  the 
great  majority  of  manufactured  articles.  Acceptances 
secured  by  warehouse  receipts  to  automobiles  and  auto- 
mobile tires  were  held  by  the  Board  in  the  January,  1920, 
Bulletin'^  to  be  unwarranted.  This  class  of  acceptances 
may  be  considered,  therefore,  as  devised  in  largest 
measure  to  meet  the  special  marketing  needs  of  the 
agricultural  borrower. 

The  restrictions  thus  far  mentioned  relate  to  the  power 
of  meml)er  banks  to  accept.  It  is  necessary  next  to  learn 
the  conditions  governing  the  power  of  reserve  banks  to 
acquire  acceptances. 

Under  its  discount  powers,  reserve  banks  can  acquire 
acceptances  maturing  within  three  months  from  date  of 
discount.  Six-months  acceptances  must  be  held,  there- 
fore, for  a  period  of  three  months  before  they  become 
eligible  for  discount  with  a  reserve  bank.  Until  May, 
192 1,  the  acceptance  was  treated  as  a  commercial  bill,  and 

^Bulletin,  March,  1920,  p.  277. 

»Cf.  Informal  Ruling,  Bulletin,  July,  1921,  p.  315. 

» Page  652. 

<  Page  65. 


174  FEDERAL  RESERVE  POLICY 

subject,  therefore,  to  the  statutory  limitations  applicable 
to  such  paper.  But  in  that  month  foreign  trade  conditions 
were  interpreted  to  be  such  as  to  warrant  an  extension  of 
maturities.  Accordingly,  in  the  desire  to  encourage  the 
granting  of  acceptances  of  longer  maturity  by  member 
banks,  an  exception  was  made  by  a  ruling  of  the  Board 
whereby  acceptancesgrowing  out  of  transactions  involving 
the  importation  or  exportation  of  goods  might  be  eligible 
for  purchase  by  reserve  banks  even  though  the  maturity 
at  the  time  of  purchase  was  as  great  as  six  months.' 
A  further  reason  for  this  regulation  was  to  widen  the 
acceptance  market  by  adapting  acceptances  to  the  re- 
quirements of  savings  banks.  Foreign-trade  acceptances 
might  be  desired  by  these  institutions  if  the  reserve 
banks  had  power  to  protect  the  market  by  acquiring 
acceptances  of  longer  maturities.  By  extending  the 
maturities  of  bills  eligible  for  purchase  the  protecting 
power  of  reserve  banks  would  be  enlarged.^ 

Bankers'  acceptances  rediscounted  under  the  terms  of 
section  13  must  be  endorsed  by  a  member  bank.  Open- 
market  purchases  under  section  14  need  not  be  endorsed. 
Nevertheless,  the  policy  of  the  Board  has  been  to  take  all 
feasible  steps  to  ensure  the  worth  of  paper  thus  acquired. 
Accordingly,  by  Section  B,  Series  of  1921,  it  was  held  that 
an  unendorsed  acceptance  "is  not  eligible  for  purchase 
until  the  acceptor  has  furnished  a  satisfactory  statement 
of  its  financial  condition,"  and  agrees  to  submit  any 
information  concerning  the  underlying  transaction  re- 
quested by  the  Federal  Reserve  bank. 

An  endorsement  by  the  accepting  bank  adds  little,  how- 
ever, to  the  strength  of  the  acceptance.  Accordingly,  the 
Board  has  not  welcomed  purchases  directly  from  the 

'  See  infra.,  pp.  191-192. 

'  Cf.  BuUelin,  June  I,  1921,  p.  648. 


DEVELOPMENT  OF  BANK  ACCEPl^ANCE       175 

accepting  bank.  It  prefers  that  the  acceptance  should  be 
acquired  from  another  bank.  It  was  only  because  of  the 
weak  market  for  acceptances  in  some  districts  that  pur- 
chase directly  from  the  accepting  institution  has  been 
condoned.  But  in  February,  1920,  reserve  banks  were 
instructed  to  make  all  such  purchases  at  the  rate  appli- 
cable to  commercial  paper  rather  than  at  the  preferential 
rate  applicable  to  bankers'  acceptances.* 

Open  market  purchases  under  section  14  are  not  subject 
to  the  requirements  of  section  13,  that  the  paper  acquired 
by  reserve  banks  shall  not  bear  the  name  of  a  borrower 
indebted  to  the  member  bank  to  an  amount  exceeding  ten 
per  cent  of  the  bank's  capital  and  surplus.  Nevertheless, 
as  a  matter  of  banking  policy  the  Board  announced  that  it 
desired  member  banks  to  recognize  this  restriction  as  ap- 
plicable to  open-market  purchases.  Discretion  in  this 
matter,  however,  is  left  to  the  district  banks. 

The  preceding  discussion  relates  exclusively  to  the 
acceptance  powers  of  member  and  reserve  banks.  By  a 
scries  of  amendments  to  section  25  of  the  act,  member 
banks  have  been  endowed  gradually  with  powers  to  invest 
in  the  stock  of  corporations  possessing  certain  acceptance 
privileges.  Let  us  turn  our  attention  next  to  this  matter  of 
syndicate  acceptance  development. 

Section  25  of  the  original  act  gave  national  banking 
associations,  with  a  capital  and  surplus  of  more  than 
^1,000,000,  power  to  establish  branches  in  foreign  coun- 
tries for  the  "furtherance  of  the  foreign  commerce  of  the 
United  States,  and  to  act,  if  required  to  do  so,  as  fiscal 
agents  of  the  United  States. "  In  the  discussion  preceding 
the  passage  of  the  act  on  December  23,  1913,  the  public 
had  been  rather  thoroughly  educated  regarding  the 
necessity  of  such  foreign  branches.    In  the  matter  of  for- 

'  Cf.  Bulletin,  June,  192 1,  p.  699. 


176  FEDERAL  RESERVE  POLICY 

cipcn  trade  some  foreign  agency  must  act  as  the  foreign 
correspondent  of  tlie  American  bank  in  such  matters  as 
the  making  of  collections  on  export  bills,  honoring  and 
issuing  letters  of  credit,  supplying  credit  information  for 
the  benefit  of  American  industry.  Foreign  banks,  under 
the  control  of,  and  devoted  primarily  to  the  welfare  of, 
foreign  industry  could  not  be  expected  to  perform  all. 
these  services  with  strict  secrecy  and  impartiality.  It  was 
a  matter  of  frequent  comment  that  American  trade 
secrets  found  frequent  disclosure  through  the  medium  of 
foreign  banks.  It  is  not  strange,  therefore,  that  our  legis- 
lators decided  to  equip  certain  types  of  our  banks  with 
powers  more  in  accordance  with  those  possessed  by  their 
foreign  banking  competitors. 

Under  the  terms  of  this  section  many  foreign  branches 
were  established.  It  soon  appeared,  however,  that  the  act 
did  not  go  quite  far  enough.  Banks  which  were  not 
desirous  themselves  of  establishing  these  foreign  branches 
insisted  that  they  should  be  permitted  to  cooperate  with 
other  banks  in  the  organization  of  foreign  banking  institu- 
tions. Accordingly,  the  amendment  of  September  7,  191 6, 
contained  a  provision  permitting  certain  types  of  banks  to 
subscribe  to  stock  in  institutions  "chartered  or  incorpo- 
rated under  the  laws  of  the  United  States  or  of  any  State 
thereof,  and  principally  engaged  in  international  or  for- 
eign banking." 

The  work  of  institutions  of  this  sort  must  be  largely  of  a 
commercial  nature.  Their  advances  must  be,  in  large  meas- 
ure, short-time  advances.  In  the  period  following  the 
signing  of  the  armistice,  however,  it  became  clear  that  the 
industrial  needs  of  Europe  were  such  as  to  demand  the 
granting  of  credits  running  for  a  relatively  long  period  of 
time.  By  a  further  amendment  to  section  25,  signed  by 
the  President  on  September  17,  191 9,  national  banks  were 


DEVELOPMENT  OF  BANK  ACCEPTANCE   177 

empowered  to  assist  in  the  formation  of  institutions  to 
provide  investment  as  well  as  commercial  credit.  Corpo- 
rations to  be  formed  under  the  authority  of  this  legislation 
must  be  "principally  engaged  in  such  phases  of  inter- 
national or  foreign  financial  operations  as  may  be  neces- 
sary to  facilitate  the  export  of  goods. " 

But  while  stock  might  be  subscribed  in  such  institu- 
tions, no  means  were  provided  for  the  Federal  incorpora- 
tion of  foreign  banking  corporations.  By  further  amend- 
ment to  section  25,  which  became  law  on  December  24, 
1919,  the  so-called  Edge  Act,  this  difficulty  was  eliminated. 

At  the  time  of  the  passage  of  the  Edge  Act  its  purpose 
was  generally  proclaimed  to  be  the  assisting  of  Europe  in 
the  reconstruction  programme.  In  the  April,  1920,  Bulle- 
tin,^ however,  we  are  informed  that  it  should  not  be  re- 
garded as  merely  of  temporary  importance.  Its  permanent 
endeavor  was  to  provide  for  the  establishment  of  federally 
incorporated  institutions  with  sufficient  power  to  compete 
on  even  terms  with  foreign  institutions.  In  Europe  insti- 
tutions of  the  type  of  the  "investment  trust"  had  long 
since  been  developed  to  encourage  foreign  trade  and  for- 
eign investment.  The  basic  purpose  of  these  institutions 
is  to  substitute  for  the  investor  domestic  for  foreign  securi- 
ties. To  obtain  capital  from  its  investing  public  its  own 
debentures  are  offered.  These  debentures  should  be  safer 
than  those  possible  of  individual  selection.  The  invest- 
ments of  the  company  are  much  more  widely  diversified 
than  an  individual's  of  limited  means  possibly  can  be. 
They  are  superintended  by  an  official  with  special  oppor- 
tunities to  investigate  the  worth  of  foreign  securities  pur- 
chased. The  investment  trust,  furthermore,  can  conduct 
its  operations  on  a  scale  impossible  for  that  of  the  indi- 
vidual.   Its  capital  is  collected  from  a  number  of  savers. 

*  Pages  379-82. 


178  FEDERAL  RESERVE  POLICY 

Finally,  the  purchaser  of  the  debentures  could  be  fortified 
by  the  knowledge  that  shrinkage  of  earnings  would  be 
borne  first  by  the  company's  shareholders,  and  that  not 
until  the  losses  wipe  out  the  capital  and  surplus  is  his  ow^n 
equity  disturbed.  Corporations  organized  in  this  coun- 
try under  the  Edge  Act  would  possess  power  to  purchase 
securities  in  companies  conducting  a  business  engaged  in 
foreign  trade. 

Corporations  formed  under  this  act  may  operate  either 
on  a  debenture  or  on  an  acceptance  basis.  In  view  of  the 
fact  that  the  framers  of  the  legislation  undoubtedly  had  in 
mind  an  institution  of  the  type  of  the  foreign  "investment 
trust, "  it  may  seem  difficult  to  account  for  its  acceptance 
powers.  It  might  appear  that  the  issuance  of  debentures 
alone  would  suffice.  It  must  be  remembered,  however, 
that  the  purpose  of  these  corporations  was  to  supply  for 
foreign-trade  purposes  short-  as  well  as  long-term  credit.  In 
the  matter  of  short-term  acceptance  credits,  member 
banks  felt  the  limitations  on  the  aggregate  permitted  by 
section  13  rather  severe.  The  Edge  Act  offers  a  means  of 
lessening  this  difficulty. 

Under  the  terms  of  the  law  the  acceptance  of  bills  and 
drafts  was  to  be  subject  to  any  limitations  and  restric- 
tions the  Federal  Reserve  Board  might  impose.  By  Regu- 
lation K,  Series  of  1920,  the  Board  has  permitted  corpora- 
tions which  issue  no  debentures  to  make  acceptances  for 
the  purpose  of  supplying  dollar  exchange  and  for  the  pur- 
pose of  furthering  the  importation  or  exportation  of  goods 
Bills  accepted  of  the  first  class  may  run  for  three  months { 
those  for  the  last  class  six  months.  For  one  drawer  accept- 
ances cannot  exceed  ten  per  cent  of  the  capital  and  surplus 
"unless  the  transaction  be  secured  or  represents  an  expor- 
tation or  importation  of  commodities  and  is  guaranteed  by 
a  bank  or  banker  of  undoubted  solvency."    Limitations 


DEVELOPMENT  OF  BANK  ACCEPTANCE      179 

upon  the  aggregate  volume  of  acceptances  were  to  be 
governed  by  the  following  regulations: 

Whenever  the  aggregate  of  acceptances  outstanding  at  any 
time  (a)  exceeds  the  amount  of  the  subscribed  capital  and  sur- 
plus, 50  per  cent  of  all  the  acceptances  in  excess  of  the  amount 
shall  be  fully  secured;  or  (b)  exceeds  twice  the  amount  of  the 
subscribed  capital  and  surplus,  all  the  acceptances  outstanding 
in  excess  of  such  amount  shall  be  fully  secured.  The  Corpora- 
tion shall  elect  whichever  requirement  (a)  or  (b)  calls  for  the 
smaller  amount  of  secured  acceptances. 

Dollar  exchange  acceptances  are  not  permitted  to  exceed 
fifty  per  cent  of  the  banks'  subscribed  capital  and  surplus. 

Although  the  liability  of  the  bank  is  only  contingent  in 
the  case  of  a  draft  drawn  under  an  acceptance  credit,  it 
seemed  desirable  to  ensure  a  sufficiency  of  liquid  assets 
against  these  acceptances.  Accordingly,  certain  reserve 
provisions  were  inserted  in  the  Regulations. 

Banks  of  this  country  displayed  no  immediate  haste  to 
take  advantage  of  this  authority  to  form  such  corpora- 
tions. In  the  early  part  of  1921  announcement  was  made 
of  the  formation  of  the  Foreign  Trade  Financing  Corpora- 
tion under  the  sponsorship  of  the  xA.merican  Bankers' 
Association.  The  capital  of  this  corporation  was  to  be 
^100,000,000.  At  that  time  there  were  only  tw^o  other 
Edge  Act  corporations  in  existence.  These  possessed  capi- 
tal stock  of  ^7,000,000  and  ^2,100,000  respectively.* 

Much  difference  of  opinion  exists  regarding  the  future 
of  such  institutions.  Lack  of  sudden  growth  may  be  ex- 
plained in  part  by  the  inevitable  friction  and  delay  in 
securing  the  large  amount  of  capital  such  institutions 
would  require.  The  depreciation  of  the  dollar  value  of 
foreign  currencies  also  rendered  it  uncertain  to  make  ad- 
vances to  foreign  traders.  The  development  of  some  such 

'  See  Report  of  the  Federal  Reserve  Board  for  lyio,  p.  26. 


i8o  FEDERAL  RESERVE  POLICY 

plan  of  supplying  international  credits  as  the  Tcr  Meulen 
may  lessen  the  future  need  of  Edge  Act  institutions.  It  has 
been  anticipated,  however,  that  the  Ter  Meulen  bond 
would  be  issued  to  importers  in  foreign  countries  largely 
for  the  purposes  of  enabling  them  to  obtain  raw  materials. 
The  supplying  of  capital  for  such  purposes  as  the  purchase 
of  machinery  may  establish  a  place  for  the  Edge  Act 
corporations. 

Full  development  of  any  institution  of  this  sort  must 
wait,  however,  in  large  measure  upon  the  rectification  of 
certain  unsound  financial  practices  employed  at  the  pres- 
ent by  European  countries.  As  long  as  these  countries 
refuse  to  balance  their  budgets  and  continue  to  meet 
deficits  by  new  creations  of  currency,  as  long  as  credits  are 
employed  for  non-reproductive  purposes,  as  long  as  cur- 
rency inflation  continues,  relief  to  Europe  will  be  difificult. 
But  these  corporations  have  another  purpose  than  aiding 
in  the  reconstruction  of  Europe.  A  leading  motive  was  to 
develop  machinery  whereby  American  financial  institu- 
tions may  be  unhampered  in  meeting  the  legitimate  re- 
quirements of  foreign  trade. 

As  a  concluding  inquiry  let  us  turn  to  the  policy  of  the 
reserve  banks  in  the  endeavor  to  encourage  the  use  of  the 
acceptance.  For  the  years  1915,  1916,  and  a  part  of  1917, 
the  discount  rate  on  bankers'  acceptances  varied  from  two 
to  four  per  cent.  The  Board  sanctioned  the  application  of 
minimum  and  maximum  figures  in  order  to  permit  reserve 
banks  to  differentiate  according  to  their  own  discretion 
between  paper  of  various  degrees  of  solvency.  In  this  early 
period  the  market  for  acceptances  was  largely  that  estab- 
lished by  the  reserve  banks.  The  paper  was  new,  and 
special  discount  corporations  had  not  been  formed  to  such 
an  extent  as  to  offer  an  immediate  market  for  this  paper. 
Accordingly,  it  was  made  possible  for  a  very  low  rate  to  be 
applied. 


DEVELOPMENT  OF  BANK  ACCEPTANCE   i8i 

There  is  no  doubt  but  that  the  reserve  authorities  were 
genuinely  eager  to  encourage  the  use  of  this  type  of  paper. 
Aside  from  any  considerations  thus  far  noted,  acceptances 
would  be  expected  to  evoke  a  more  intense  foreign  demand 
than  that  for  any  other  grade  of  paper.  With  such  a  for- 
eign market  created,  it  was  hoped  that  it  woukl  be  possible 
to  shift  the  purchase  from  London  to  New  York  by  alter- 
nate changes  in  discount  rates. 

During  1917,  however,  the  rates  hardened.  By  the  end 
of  the  year  they  had  risen  to  3  to  4  1/2  per  cent,  except  for 
three  reserve  banks  where  the  rates  were  3  to  5  per  cent. 
The  latter  part  of  the  year  open-market  charges  on  bank- 
ers' acceptances  maturing  within  3  months  were  4  per 
cent  as  a  minimum.  This  was  slightly  less  than  the  rates 
on  61-90-day  paper  secured  by  United  States  war  obliga- 
tions (4  1/4  per  cent).  Relatively  the  same  figures  were 
maintained  during  the  year  1918. 

This  lessening  of  the  rate  advantage  given  to  the  accept- 
ance may  be  explained  on  several  grounds.   First, 

It  was  thought  that  a  lower  rate  for  any  class  of  paper  than 
that  borne  by  member  banks'  15-day  collateral  notes  secured 
by  Government  obligations  might  have  an  unfavorable  effect 
upon  the  Treasury's  operations.' 

In  other  words,  it  was  not  desired  to  do  anything  which 
might  interfere  with  the  sale  or  the  market  for  war  securi- 
ties. Secondly,  sufficiently  good  progress  had  been 
achieved  in  the  acceptance  movement  to  render  less  neces- 
sary an  extremely  low  preferential  rate.  The  increase  in 
the  open-market  purchases  by  Federal  Reserve  banks  is 
indicated  by  the  following  figures:^ 

1915 $     64,845,000 

i()i6 3.S6,o(j5,()00 

19 1 7 909,301,000 

1918 1,809,539,000 

» Report  of  the  Federal  Reserve  Hoard  for  k;  18,  p.  19.  '  Ibid. 


182  FEDERAL  RESERVE  POLICY 

Finally,  money-market  conditions  during  191 8  were 
such  as  to  render  it  unnecessary  to  endeavor  to  meet  the 
lower  British  rate.  Free  shipments  of  gold  were  suspended 
and  connection  between  the  two  markets  was  destroyed. 
The  higher  rate  exacted  here  did  not  mean  the  driving  of 
financing  to  London  because  of  the  disturbances  wrought 
in  foreign  trade  and  finance. 

Since  19 18  the  policy  of  the  reserve  administration  has 
been  to  establish  a  greater  similarity  for  the  different 
classes  of  paper  of  corresponding  maturities.  On  Decem- 
ber 21,  1 92 1,  the  average  rates  charged  on  bankers'  accept- 
ances maturing  within  three  months  was  the  same  as  the 
commercial  paper  rate.  Figures  showing  the  purchases  by 
reserve  banks  from  1917  to  1920  were  as  follows:* 

ACCEPTANCES  BOUGHT  IN  OPEN  MARKET  BY  RESERVE  BANKS 

I9I7 $     909,301,000 

I918 1,809,539,000 

I9I9 2,825,177,000 

1920 3,218,364,000 

The  holdings  of  reserve  banks  of  bankers'  acceptances 
on  certain  dates  of  1920  and  192 1  were  as  follows:' 

END  OF 

September,  1920 $306,295,000 

December,  1920 276,096,000 

March,  1921 132,106,000 

June,  1921 48,586,000 

September,  1921 45,761,000 

These  figures  show  a  decided  falling  off  in  the  acceptance 
activities  of  reserve  banks  during  the  year  192 1.  A  similar 
decline  is  indicated  by  available  figures  bearing  on  member 
bank  acceptance  activities.  Through  inquiries  sent  out  by 
the  American  Acceptance  Council  it  was  ascertained,  in 

'  Report  of  the  Federal  Reserve  Board,  1920,  p.  52. 
'Bulletin,  November,  192 1,  p.  1269. 


DEVELOPMENT  OF  BANK  ACCEPTANCE   183 

417  answers  out  of  482  inquiries,  that  bankers'  acceptances 
outstanding  on  April  i,  1920,  amounted  to  as  much  as 
^799,000,000.  By  April  i,  1921,  this  figure  had  shrunk  to 
^644,000,000.  Investigation  of  the  Federal  Reser\-e  Board 
indicates  an  approximately  similar  decline  for  the  same 
period.^ 

Many  factors  serve  to  account  for  the  decline  in  accept- 
ances in  possession  of  reserve  banks  in  192 1.  The  lessening 
volume  of  foreign  trade  and  the  fact  that  the  preferential 
rate  enjoyed  by  the  acceptance  has  been  virtually  elimi- 
nated have  retarded  both  the  necessity  and  the  desire  of 
member  banks  to  finance  in  this  way.  The  general  easing 
of  the  money  market  has  enabled  many  banks,  which 
would  depend  otherwise  upon  the  acceptance,  to  finance 
their  clients  by  the  straight  loan.  At  the  same  time,  the 
improvement  in  the  money  market  has  enabled  many 
banks  to  hold  in  their  own  portfolios  acceptances  pur- 
chased, until  maturity.  On  the  part  of  foreign  branch 
banks  there  has  been  an  increased  competition  with  the 
reserve  banks  in  the  purchase  of  this  paper.  This  latter 
fact  would  not  concern,  however,  the  operations  of  mem- 
ber banks. 

Despite  these  facts  long-time  prospects  for  the  accept- 
ance development  appear  favorable.  In  some  States,  such 
as  New  York  and  Massachusetts,  recent  legislation  per- 
mits savings-bank  acquirement  of  acceptances.  The 
Board's  ruling  in  May,  1921,  lengthening  the  maturity  of 
eligible  acceptances  to  six  months,  should  render  this 
paper  more  desirable  for  savings  banks.  As  the  period  of 
depression  gives  way  to  activity,  more  and  more  situa- 
tions will  arise  in  which  customers'  requirements  will  be 
too  heavy  to  be  met  by  direct  advances.  Education  and 
propaganda,   moreover,   may   accomplish   much,   and   a 

'  Bulletin,  July,  iy2i,  pp.  775-76. 


i84  FEDERAL  RESERVE  POLICY 

great  deal  of  work  still  remains  for  some  reserve  banks  in 
lending  their  facilities  to  member  banks  in  the  purchase  of 
acceptance  paper. 

The  future  development  of  the  acceptance  market  is 
highly  necessary.  Otherwise,  surplus  funds  of  member 
banks  will  again  be  entrusted  in  large  volume  to  the  call- 
money  market.  The  call-money  market  is  not  under  the 
direct  control  of  the  reserve  system.  Stock  exchange  paper 
is  not  eligible  for  rediscount  or  purchase. 


CHAPTER  IX 

THE    OPEN-MARKET    OPERATIONS    OF    RESERVE 

BANKS 

In  the  mind  of  the  pubHc  much  confusion  has  existed 
regarding  the  difference  between  the  open-market  and  dis- 
count operations  of  the  reserve  banks.  The  first  class  of 
operations  are  authorized  by  section  14  of  the  act,  and  the 
latter  class  by  section  13.  But  in  what  way  can  a  distinc- 
tion be  made  between  the  character  of  the  work  which  can 
be  performed  under  the  authority  of  these  two  sections? 

A  widely  accepted  belief  has  been  that  in  the  open-mar- 
ket operations  the  reserve  banks  deal  directly  with  the 
public;  whereas  by  their  discount  powers  they  operate 
only  with  the  member  banks.  Color  is  lent  to  this  view  by 
noting  certain  facts  about  the  early  legislative  history  of 
the  act.  The  report  by  Chairman  Glass  for  the  House 
Banking  and  Currency  Committee  on  September  9,  1913,' 
contained  the  following  statement: 

It  [the  committee]  recommends  that  these  bankers'  banks 
shall  be  given  a  definite  capital,  and  that  they  shall  do  business 
only  with  the  banks  aforesaid,  and  with  the  Government. 

The  later  inclusion  of  section  14  in  the  act  is  interpreted, 
therefore,  as  the  extension  to  reserve  banks  of  powers  to 
deal  directly  with  the  public.  However  this  may  be,  sec- 
tion 14  of  the  final  bill  authorized  reserve  banks  to  "pur- 
chase and  sell  in  the  open  market,  .  .  .  either  from  or  to 
domestic  or  foreign  banks,''''  certain  specified  classes  of  paper. 

«  House  Report,  63CI  Congress,  1st  Session,  pp.  16  d  scq. 
*  Italics  arc  the  writer's. 


1 86  FEDERAL  RESERVE  POLICY 

Under  the  terms  of  this  section  reserve  l^anks  may  deal 
with  bantcs.  All  that  can  be  said  for  this  point  of  view, 
therefore,  is  that  the  open-market  powers  are  the  sole 
authorization  for  direct  dealings  with  individuals  and  cor- 
porations. Such  powers  are  not  granted  by  section  13. 
Section  14  also  permits  a  reserve  bank  to  deal  with  other 
than  its  own  member  banks.  It  may  buy  or  sell  certain 
types  of  securities  and  commercial  paper  from  or  to  mem- 
ber banks  in  other  districts.  It  cannot  rediscount  under 
section  13  for  the  member  banks  of  other  districts. 

Neither  can  complete  distinction  be  found  by  noting 
whether  there  has  been  endorsement  by  the  member  bank 
of  the  paper  offered  the  reserve  bank.  It  is  true  that  redis- 
counted  paper  must  be  endorsed  by  member  banks, 
whereas  the  statute  does  not  require  paper  purchased 
under  the  authority  of  section  14  to  be  endorsed.  Never- 
theless, the  Board  has  endeavored  by  its  regulations  to 
encourage  the  practice  of  giving  precedence  to  endorsed 
paper  in  the  reserve  banks'  open-market  purchases. 

Nor  can  conclusive  distinction  be  had  by  noting  the  types 
of  paper  which  may  be  acquired  under  the  authority  of  the 
two  sections.  It  is  true  that  certain  types  of  Government 
securities  and  municipal  warrants  may  be  purchased 
under  section  14  only,  and  that  promissory  notes 
can  be  acquired  by  reserve  banks  only  by  a  discount 
authorized  by  section  13.  The  original  bill  permitted  the 
open-market  purchase  of  "notes,  drafts,  and  bills  of  ex- 
change." But  in  the  final  draft  the  words  "notes"  and 
"drafts"  were  stricken  out  of  section  14,  although  they  are 
retained  in  section  13.  But  even  after  these  alterations 
bankers'  acceptances  and  bills  of  exchange  could  be  dealt 
in  by  the  authority  granted  by  either  section.  Classifica- 
tion of  securities  and  paper  in  the  two  sections  overlaps. 

In  the  case  of  bank  acceptances,  however,  nearly  all  the 


OPEN-MARKET  OPERATIONS  187 

paper  acquired  from  mem1x?r  banks  has  been  in  accordance 
with  the  authority  granted  by  section  14.  This  is  due  to 
the  fact  that  the  rate  on  prime  acceptances  bought  in  the 
open  market  has  been  lower  than  the  rediscount  rate  for 
commercial  or  agricultural  paper.  The  principal  exception 
to  this  statement  relates  to  bankers'  acceptances  unen- 
dorsed by  a  bank  or  banker  other  than  the  acceptor.  In 
this  latter  case  the  higher  rate  on  rediscounted  paper 
applies. 

If  the  paper  is  authorized  by  both  sections  and  is  ac- 
quired from  a  member  bank,  section  14  must  be  regarded, 
therefore,  as  conferring  additional  powers  by  which  reserve 
banks  may  deal  with  member  banks.  As  stated  previously, 
however,  the  open-market  regulations  have  been  such  as  to 
discourage  the  applications  of  member  banks  involving 
paper  not  of  the  highest  degree  of  liquidity. 

In  view  of  the  fact  that  the  House  Committee  in  its 
report  of  September  9,  1913,  recommended  that  the  bank- 
ers' banks  must  confine  their  dealings  to  member  banks  and 
the  Government,  it  is  peculiarly  interesting  to  inquire  into 
the  motives  which  led  to  the  inclusion  of  the  open-market 
section  in  the  final  bill.  It  was  understood,  of  course,  how 
desirable  such  powers  would  be  in  enabling  reserve  banks 
to  make  profitable  investment  of  their  surplus  funds.  On 
occasions  when  the  volume  of  rediscounting  falls  off,  the 
earnings  of  reserve  banks  would  diminish  unless  they  could 
be  permitted  to  go  out  in  the  open  market  and  find  invest* 
ment  use  for  their  funds.  This  consideration  would  hold 
for  any  central  banking  system.  But  the  structure  of  the 
Federal  Reserve  was  such  as  to  render  it  peculiarly 
necessary  that  the  district  banks  possess  these  powers. 
Member  banks  were  compelled  to  subscribe  to  the  stock  of 
the  reserve  banks.  Their  interest  and  enthusiasm  in  the 
new  system  must  pall  unless  a  reasonable  dividend  is 


1 88  FEDERAL  RESER\T.  POLICY 

received  on  stock  subscriptions.  At  least,  it  is  not  desirable 
that  reserve  banks  operate  at  a  direct  loss. 

Open-market  operations,  moreover,  represent  under 
some  situations  the  only  effective  means  whereby  reserve 
banks  can  take  aggressive  action  in  the  control  of  the  money 
market.  There  can  be  no  rediscounting  unless  the  member 
banks  take  the  initiative  by  making  applications  to  the 
reserve  banks.  On  occasions  when  member  banks'  reserves 
are  plentiful,  increase  in  rediscount  rates  may  result  in  no 
correction  of  member  banks'  practices  in  advancing  credits 
freely.  Member  banks  may  then  ignore  the  advice  and 
warnings  of  the  reserve  administration.  Accordingly,  if 
the  reserve  banks  are  to  be  more  than  a  mere  set  of  emer- 
gency institutions,  they  should  be  given  power  to  effect 
general  money-market  conditions  by  their  purchases  or 
by  their  sales.  Such  measures  are  especially  necessary  in 
the  endeavor  to  realize,  first,  more  uniform  rates  through- 
out the  country;  and,  second,  to  control  the  Nation's  gold 
movements  in  such  a  way  as  to  avoid  excessive  outflow  at 
one  period  followed  by  enormous  inflow  in  another.  Direct 
sale  and  purchases  are  needed  to  accomplish  the  first  result 
when  banks  in  other  districts  are  not  attracted  by  the 
higher  rates  in  the  capital-poor  sections.  As  a  matter  of 
fact,  there  have  always  been  many  obstacles  in  the  way  of 
the  free  flow  of  bank  funds  to  the  district  of  high  rates. 
Rediscounting  alone  may  not  afTect  the  situation  markedly. 
In  the  matter  of  controlling  gold  movements,  a  principal 
past  difficulty  has  been  the  inability  of  our  many  ex- 
change-dealing banks  to  adopt  a  unified  policy  regarding 
alterations  in  our  discount  rates  as  it  appeared  necessary 
to  attract  or  to  repel  gold.  No  institution,  furthermore,  was 
charged  with  the  responsibility  of  accumulating  the  supply 
of  foreign  credits  which  could  be  drawn  upon  in  lieu  of 
gold  shipments  in  time  of  a  declining  exchange. 


OPEN-MARKET  OPERATIONS  1S9 

Finally,  it  was  anticipated  that  some  of  the  oprn-markot 
powers  would  prove  very  helpful  in  encouraging  the  use 
of  dollar  credits.  If  foreign  countries  are  to  be  induced  to 
employ  dollar  exchange  as  a  means  of  international  pay- 
ment, they  must  be  satisfied  that  a  ready  market  will  exist 
in  this  country  for  the  discount  of  the  bills  which  their 
bankers  and  merchants  draw.  When  the  domestic  market 
fails  for  prime  bills  of  this  sort,  the  reserve  banks  must 
protect  it  by  their  purchases.  In  opposite  fashion,  the 
institution  responsible  for  the  control  of  the  Nation's 
gold  movements  should  be  given  power  to  establish  credits 
abroad  which  may  be  drawn  upon  in  times  when  the 
balance  of  payment  is  unfavorable.  Such  drawings  may 
make  unnecessary  shipments  of  gold.  Accordingly,  certain 
specified  types  of  operations  are  permitted  by  section  14 
in  order  to  accomplish  this  purpose. 

One  aspect  of  this  question  is  of  peculiar  importance 
in  the  establishment  of  the  dollar  exchange.  This  is  the 
matter  of  quoting  forward  discount  rates.  As  stated  by 
Paul  M.  Warburg  before  the  Pan-American  Financial 
Conference :  * 

A  bank  in  a  foreign  country,  when  buying  a  dollar  acceptance, 
must  be  assured  of  the  rate  at  which  the  bill  will  be  discounted 
when  it  reaches  our  country.  On  this  rate  it  will  largely  depend 
whether  the  foreign  shipper  will  use  his  European  or  his  Ameri- 
can credit  facilities.  The  Federal  Reserve  banks  are  fully  alive 
to  the  importance  of  this  question,  and  I  may  state  on  behalf 
of  some  of  the  largest  of  these  banks  that  they  will  be  prepared 
to  give  the  greatest  possible  assistance  by  adopting  a  liberal 
policy  in  quoting  such  forward  rates,  good  for  a  certain  date  or 
for  delivery  upon  the  arrival  of  mail  by  a  given  steamer. 

It  seemed  clear  to  the  framers  of  the  act  that  paper 
permissible    for   open-market    dealings    must    be    highly 
»  Quoted  from  BuUeiin,  July  i,  1915,  pp.  132-36. 


190  FEDERAL  RESERVE  POLICY 

liquid.  Purchases  at  one  season  or  year  become  sales  at 
another.  Control  of  the  market  involves  sales  quite  as 
much  as  purchases.  It  was  insisted,  therefore,  that  reserve 
banks  should  not  buy  large  amounts  of  paper  or  vsecurities 
which  would  not  command  a  broad  market  in  the  period 
when  it  is  desired  to  unload. 

It  may  seem  strange,  therefore,  to  note  the  inclusion  in 
section  14  of  certain  classes  of  investment  paper.  Through- 
out the  act,  the  underlying  theory  appears  to  be  that 
short-time  paper  growing  out  of  commercial  transactions 
is  preferable  to  investment  paper  as  an  item  in  reserve 
banks'  portfolios.  It  might  seem  as  if  investment  paper 
would  have  been  excluded  in  section  14  quite  as  throughly 
as  in  section  13.  But  there  was  the  desire  to  make  the 
Federal  Reserve  system  of  especial  service  to  the  Federal 
Government  and  the  local  subdivisions.  Accordingly, 
by  section  14,  permission  is  given  for  investment  in  certain 
specified  classes  of  Government  securities.  As  a  matter  of 
fact,  similar  powers  are  granted  by  section  13.  Therein  eli- 
gible paper  is  made  to  include  that  drawn  for  the  purpose  of 
carrying  or  trading  in  bonds  and  notes  of  the  Government 
of  the  United  States.  On  purely  financial  grounds  it  might 
have  been  argued  that  Government  securities  frequently 
rise  in  price  in  time  of  extensive  liquidation.  The  fear  at- 
taching to  private  securities  in  period  of  liquidation  seems 
often  to  increase  the  demand  for  Governments.  These  se- 
curities possess  a  more  stable  market  than  the  general 
mass  of  obligations  issued  by  private  corporations. 

Paper  purchasable  under  section  14  falls  into  four  classes. 
We  may  mention  first  the  Governments.  Section  14b 
states  that  reserve  banks  may 

buy  and  sell,  at  home  or  abroad,  bonds  and  notes  of  the  United 
States,  and  bills,  notes,  revenue  bonds,  and  warrants  with  a 
maturity  from  date  of  purchase  of  not  exceeding  six  months, 


OPEN-MARKET  OPERATIONS  191 

issued  in  anticipation  of  the  collection  of  taxes  or  in  anticipation 
of  the  receipt  of  assured  revenues  by  any  State,  county,  dis- 
trict, political  subdivision,  or  municipality  in  the  continental 
United  States,  including  irrigation,  drainage  and  reclamation 
districts,  .  .  . 

Two  facts  in  this  sentence  deserve  emphasis.  In  the 
first  place,  municipal  warrants  must  be  issued  solely  in 
anticipation  of  later  receipts.  Fears  as  to  the  wisdom  of 
including  them  may  be  mollified  somewhat  on  this  ac- 
count. In  the  second  place,  irrigation  and  reclamation 
districts  are  included  in  the  class  of  governmental  sub- 
divisions whose  issues  are  purchasable  under  the  authority 
of  this  section.  There  appears  to  be  no  attempt  here  to 
discriminate  against  agriculture  or  land-development. 

A  second  class  of  open-market  paper  consists  of  bills  of 
exchange  and  bankers'  acceptances.  Need  for  these  powers 
has  been  explained  in  previous  chapters.  The  bankers* 
acceptance  is  peculiarly  necessary  for  foreign-trade  financ- 
ing and  it  was  believed  that  its  rapid  development  necessi- 
tated the  sponsorship  of  central  banking  authority. 

An  interesting  question  relates  to  the  period  within 
which  purchasable  bankers'  acceptances  must  mature. 
This  section  empowers  reserve  banks  to  purchase  and  sell, 
in  the  open  market, 

cable  transfers  and  bankers'  acceptances  and  bills  of  ex- 
change of  the  kinds  and  maturities  by  this  Act  made  eligible 
for  rediscount,  .  .  . 

Since  discounted  paper,  by  the  terms  of  section  13, 
must  be  payable  within  three  months,  it  might  appear  as 
if  purchasable  bankers'  acceptances  must  have  no  longer 
maturity.  If  this  be  true.  It  woukl  be  jiuzzHng  to  under- 
stand the  legal  authority  for  the  Board's  Regulation  B,  as 
amended  in  May,  1921,  wherein  reserve  banks  arc  author- 


192  FEDERAL  RESERVE  POLICY 

izod  to  purchase  bankers'  acceptances  arisinj^  out  of 
foreign-trade  transactions  and  having  maturities  as  extended 
as  six  months.^ 

In  reply  to  the  writer's  query  on  this  matter  the  Board 
stated  its  position  as  follows: ' 

The  question  of  whether  the  Board's  regulation  authorizing 
the  purchase  of  six-months'  acceptances  is  in  conflict  with  the 
terms  of  the  Federal  Reserve  Act  depends  upon  whether  or  not 
the  phrase  "of  the  kinds  and  maturities  by  this  act  made  eligible 
for  rediscount"  refers  both  to  bankers'  acceptances  and  to  bills 
of  exchange  or  refers  only  to  bills  of  exchange.  It  cannot,  of 
course,  refer  to  cable  transfers,  because  cable  transfers  are  not 
eligible  for  rediscount  under  any  circumstances.  The  phrase 
might,  however,  qualify  both  bankers'  acceptances  and  bills  of 
exchange  or  might  qualify  only  bills  of  exchange.  The  Federal 
Reserve  Board  has  always  interpreted  it  as  applying  only  to 
bills  of  exchange,  and  in  its  regulations  of  the  Series  of  19 15, 
1916,  1917,  and  1920,  it  has  authorized  the  purchase  in  the  open 
market  by  Federal  reserve  banks  of  acceptances  growing  out 
of  the  domestic  storage  of  goods,  although  the  only  acceptances 
eligible  for  rediscount  as  growing  out  of  domestic  storage  trans- 
actions are  those  growing  out  of  the  storage  of  readily  market- 
able staples.  The  term  "goods"  is,  of  course,  more  inclusive 
than  the  term,  "readily  marketable  staples."  Consequently, 
the  Board's  Regulation  B,  Series  of  192 1,  making  eligible  for 
purchase  in  the  open  market,  subject  to  certain  conditions, 
acceptances  with  maturities  not  in  excess  of  six  months  which 
grow  out  of  foreign  transactions,  was  not  predicated  upon  any 
new  interpretation  of  the  law. 

Looking  only  at  the  language  of  this  particular  provision  of 
the  Federal  Reserve  Act,  it  is  not  clear  whether  the  phrase 
"of  the  kinds  and  maturities  by  this  act  made  eligible  for  re- 
discount" qualifies  both  bankers'  acceptances  and  bills  of 
exchange  or  qualifies  only  bills  of  exchange,  but  as  heretofore 
indicated  the  latter  interpretation  now  has  the  sanction  of  estab- 
lished usage,  and  this  would,  I  think,  have  great  weight  with  any 

'  See  supra,  p.  174. 

»  In  a  letter  to  the  writer. 


OPEN-MARKET  OPERATIONS  193 

court  which  had  to  pass  upon  the  question.  Furthermore,  the 
legislative  history  of  the  Federal  Reserve  Act  indicates  that  the 
Board's  interpretation  of  the  i)rovisi()n  is  the  correct  one.  The 
corresponding  paragraph  of  the  bill  as  first  passed  the  House  of 
Representatives  provided  "That  any  Federal  reserve  bank 
may,  under  rules  and  regulations  prescribed  by  the  Federal 
Reserve  Board,  purchase  and  sell  in  the  open  market,  .  .  . 
prime  bankers'  bills,  and  bills  of  exchange  of  the  kinds  and 
maturities  made  eligible  for  rediscount,  and  cable  transfers." 
The  words  "and  bills  of  exchange  of  the  kinds  and  maturities 
by  this  act  made  eligible  for  rediscount"  thus  constituted  one 
separate  and  complete  clause  with  a  comma  at  the  beginning 
and  at  the  end,  and  it  is  quite  clear  that  the  term  "prime  bank- 
ers' bills"  was  not  intended  to  be  qualified  by  the  words  "of 
the  kinds  and  maturities  by  this  Act  made  eligible  for  redis- 
count." There  is  nothing  to  indicate  that  the  subsequent 
amendment  which  the  Senate  made  in  the  phraseology  of  the 
provision  was  intended  to  give  any  broader  application  to  the 
phrase  "Of  the  kinds  and  maturities  by  this  Act  made  eligible 
for  rediscount,"  and  the  fact  that  the  provision  as  thus  amended 
is  at  least  ambiguous  is  indicative  of  the  absence  of  such  intent. 

The  last  class  of  permitted  open-market  powers  re- 
lates to  dealings  in  cable  transfers  and  gold  coin  and 
bullion.  Section  14  states  that  reserve  banks  shall  have 
power 

to  deal  in  gold  coin  and  bullion  at  home  or  abroad,  to  make 
loans  thereon,  exchange  Federal  reserve  notes  for  gold,  gokl 
coin  or  gold  certificates,  and  to  contract  for  loans  of  gold  coin 
or  bullion,  giving  therefor,  when  necessary,  acceptable  security, 
etc.,  etc. 

These  powers  were  conceived  to  be  necessary  in  order  to 
enable  the  reserve  banks  to  exercise  some  control  over  the 
exchange  market  and  to  protect  the  dollar  exchange.  By 
acquiring  foreign  credits  or  accumulating  gold  holdings 
abroad  the  reserve  banks  may  be  able  to  provide  American 
industry   with   the   means  of   foreign   payment  on   such 


194  FEDERAL  RESERVE  POLICY 

occasions  as  mipjht  otherwise  result  in  a  depreciation  in  the 
dollar  or  an  excessive  outflow  of  gold. 

The  reserve  system  went  into  operation  in  a  period 
marked  by  much  confusion  and  uncertainty.  In  the  haste 
to  secure  the  functioning  of  the  system  it  was  not  deemed 
essential  that  provision  be  made  at  the  outset  for  the 
complete  exercise  of  its  open-market  functions.  Accord- 
ingly, 

the  Board  determined  to"confine  itself  in  the  beginning  to  those 
matters  which  were  deemed  absolutely  essential  to  setting  the 
banks  in  motion  upon  a  basis  of  reasonable  efificiency.  It  was 
felt  that  the  regulations  relating  to  discount  operations  and 
commercial  paper  in  general  were  fundamental  and  they  should 
be  prepared  and  issued  at  once.^ 

Nevertheless,  on  December  i8,  1914,  authority  was  given 
for  the  purchase  of  Government  (bonds.  Shortly  after- 
wards, December  23,  regulations  were  sent  out  relating 
to  the  purchase  of  warrants  and  municipal  bonds.  Early 
in  191 5  regulations  were  issued  relating  to  bankers'  ac- 
ceptances, and  by  a 

letter  of  October  8,  confirmed  by  a  circular  and  regulation  of 
December  6,  the  Board  authorized  the  several  institutions  to 
purchase,  at  rates  to  be  fixed  by  them  within  certain  limits 
prescribed  by  the  Federal  Reserve  Board,  all  those  classes 
of  bills  of  exchange  which  are  by  the  Act  made  eligible  for 
rediscount. 

Several  points  in  these  circulars  deserve  mention.  The 
first  relates  to  the  purchase  of  acceptances.  By  Circular  19 
of  November  29,  191 5,  reserve  banks  were  authorized  to 
purchase  domestic  as  well  as  foreign-trade  acceptances. 
Since  the  act  permitted  national  banks  to  accept  only  to 
finance  transactions  arising  out  of  the  importation  or 
exportation  of  goods,  the  question  may  arise  as  to  the 

*  Report  of  the  Federal  Reserve  Board,  1914,  pp.  8-9, 


OPEN-MARKET  OPERATIONS  195 

source  of  domestic-trade  acceptances.  The  answer  is 
that  since  the  enactment  of  the  Federal  Reserve  Act  a 
number  of  States  had  adopted  legislation  permitting  the 
domestic  acceptance,  and  these  were  made  eligible  by  the 
Board  for  purchase  by  the  reserve  banks.  This  action 
foretold  the  later  advocacy  by  the  Board  of  an  amendment 
to  the  act  permitting  national  banks  to  accept  for  domestic- 
trade  purposes.  If  such  action  was  not  anticipated,  the 
Board  probably  would  not  have  made  State  bank  domestic 
acceptances  purchasable  by  reserve  banks.  It  was  also 
advocated  in  this  circular  that  reserve  banks  should  give 
preference 

to  acceptances  endorsed  by  a  member  bank,  discounted  under 
section  13,  not  only  because  of  the  additional  protection  that 
such  endorsement  affords  but  also  because  of  the  reason  that 
acceptances  discounted  under  section  13  may  be  used  as  col- 
lateral security  for  the  issue  of  Federal  Reserve  notes.' 

Particularly  because  of  the  disturbed  conditions  abroad, 
the  Board  advocated  caution  in  foreign-exchange  dealings. 
While  the  Board  did  not  insist  that  foreign  bills  of  exchange 
should  be  accepted  before  purchase,  it  did  rule  that 
unaccepted  bills  either  should  be  secured  by  documents  or 
bear  a  satisfactory  endorsement  other  than  that  of  the 
acceptor  or  drawer. 

After  the  issuance  of  these  circulars  reserve  banks  were 
authorized  to  exercise  to  the  full  extent  permitted  the 
powers  conferred  by  section  14.  In  view  of  the  fact  that 
the  open-market  section  evidences  more  clearly  than  any 
other  the  intention  of  the  framers  that  the  reserve  banks 
should  operate  continuously  and  not  merely  during  emer- 
gencies, it  is  especially  necessary  to  note  the  use  which  has 
been  made  of  these  powers.   The  following  figures  enable 

•  Circular  No.  20.  By  amonclments  to  the  original  act  acceptances  purcIiascU 
under  section  14  niay  be  used  a^  collateral  security  for  !■  eUeral  Reserve  notes. 


196 


FEDERAL  RESERVE  POLICY 


comparisons  to  be  made  between  the  volume  of  the  discount 
and  open-market  operations  by  years  from  191 5  to  1920: 


1 

2 

3 

4 

S 

6 

Year 

Total  Bills 

DiSCOU.NTED 

FOR  Me.mber 
Banks 

Acceptances 
Bought  in 
the  Open 
Market' 

United 
States  Secur- 
ities and 
Municipal 
Warrants 

Total 
Invest.ment 
Operations 

Per 
Cent 

OF 
1   TO  4 

Per 

Cent 

OF  Open 

Market 

TO  4 

1915.. 
1916. . 

1917.  . 

1918.  . 

1919.  . 
1920.. 

$      161,35.3,000 

207,870,500 

9,014. 180,454 

39.752.933,847 

79.173,969,730 

85,320,874,000 

S      64,845,000 
386,09.S,000 
1,077,712,509 
1,809,538,795 
2,825,177,002 
3.218,364.000 

S      81,572.770 

147.436.180 

105,421,882 

5,852,058,075 

4,737,920,421  ^ 

7,988.310,000  3 

$      307,770.800 
741,401 .6  SO 
10,197,320,845 
47,414,530,717 
86,737,067,153 
96,527,548,000 

52.4 
28.3 
88.3 
83.7 
91.3 
88.3 

47.6 
71.7 
11.7 
16.3 
8.7 
11.7 

I  The  first  purchase  of  bankers'  acceptances  was  made  February  15,  1915. 
sincludes  only  $1000  of  municipal  warrants. 
3  No  purchases  of  municipal  warrants. 

In  the  early  years  of  operation,  191 5  and  191 6,  the  open- 
market  operations  were  relatively  very  important.  There 
was  then  little  demand  for  discounts,  and  reserve  banks 
were  forced  to  make  open-market  purchases  in  order  to  find 
even  moderate  employment  for  their  funds.  In  these  years 
the  reserve  ratios  of  the  reserve  banks  were  very  large. 
But  after  the  outbreak  of  the  European  War  the  discounts 
requested  by  member  banks  were  so  great  that  open-market 
purchases  declined  in  comparison.  In  aggregate  volume, 
however,  they  increased  year  by  year  without  interruption. 
In  every  year  from  191 5  to  1920  the  total  volume  of  open- 
market  purchases  exceeded  that  of  the  previous  year. 

One  of  the  most  interesting  objections  to  the  open-market 
provisions  of  the  Reserve  Act  was  voiced  by  Miss  Anna 
Youngman  in  the  September,  1921,  number  of  the  Amer- 
ican Economic  Review.^  She  argued  that  it  was  a  mistake 
to  endeavor  to  discriminate  against  the  promissory  note  in 
reserve  banks'  purchase  operations.  Our  trade  credit 
system  is  based  upon  the  note  and  not  upon  the  bill  of 

'  Pages  463-85.  The  Efficacy  of  Changes  in  Didcount  Kates  of  Federal  Re- 
serves Banks. 


OPEN-MARKET  OPERATIONS  197 

exchange,  and  attempts  to  foster  the  use  of  the  bank  ac- 
ceptance do  not  appear  to  her  to  have  been  exceptionally 
successful.  She  calls  attention  to  the  decline  in  the  volume 
of  bankers'  acceptances  in  192 1,  and  alludes  to  the  fact  that 
this  decline  would  have  been  all  the  more  startling  were  it 
not  for  the  large  volume  of  acceptance  credits  covering 
sugar  and  those  granted  for  the  creation  of  dollar  exchange. 
Bankers'  acceptances  appear  to  her  of  principal  \-alue  in 
foreign-trade  transactions.  Accordingly,  the  present  open- 
market  policy  of  the  reserve  banks  is  characterized  as  an 
attempt  to  secure  effective  control  of  the  market  by  confin- 
ing dealings  to  a  paper  arising  in  a  small  and  relatively  un- 
important class  of  transactions.  She  advocates  that  reserve 
banks'  open-market  powers  should  be  extended  to  include 
notes  as  well  as  bills  growing  out  of  commercial  transactions. 
It  also  seemed  plausible  to  her  that,  to  a  limited  extent, 
reserve  banks  should  be  permitted  to  purchase,  as  well  as 
discount,  paper  representing  loans  on  stock  exchange 
collateral. 

Miss  Youngman's  objection  to  great  dependence  upon 
the  bafhkers'  acceptance  is  also  based  upon  her  belief  that 
the  market  for  this  paper  is  highly  uncertain.  There  is  the 
competitive  English  demand  for  bankers'  acceptances,  and 
the  English  rate  must  be  met  if  the  financing  is  to  be  done 
in  the  New  York  market.  As  long  as  acceptances  grow 
largely  out  of  international  transactions,  reserve  bankg 
must  come  to  the  rescue  of  dealers  when  the  English  rate  is 
lowered,  even  though  such  action  is  contrary  to  our  own  in- 
vestment needs.  Open-market  transactions  in  commercial 
paper  should  be  based  more  largely  upon  domestic  paper. 

Her  argument  for  extending  reserve  bank  operations  to 
stock  exchange  paper  is  based  upon  the  belief  that  all  money 
rates  should  be  subject  to  influence,  if  not  to  control,  by 
tlie  reserve  banks.    Unless  call  rates  can  be  influenced  by 


198  FEDERAL  RESERVE  POLICY 

reserve  activities,  rates  on  other  loans  are  also  difficult  to 
influence.  To  a  certain  degree  banks  have  their  choice  in 
selecting  the  market  which  offers  highest  compensation. 
The  reserve  banks  shoukl  \xt  in  a  position  to  break  abnor- 
mally high  rates  by  direct  lending.  If  they  cannot  do  so, 
their  rediscount  policy  may  be  rendered  futile. 

The  reader's  reaction  to  these  somewhat  revolutionary 
views  will  depend  largely  upon  the  degree  of  control  he  is 
willing  to  repose  at  the  present  time  in  the  reserve  adminis- 
tration. Granted  that  the  reserve  banks  can  be  managed 
impartially,  with  economic  foresight,  without  fear  of 
political  hostility,  the  argument  is  entirely  in  favor  of 
widening  the  classes  of  open-market  paper.  The  greater 
the  variety  of  paper  which  can  be  dealt  in,  the  more  com- 
plete the  power  of  the  reserve  administration.  Possibilities 
of  evil  are  also  greater.  The  reserve  banks  are  governed  by 
men,  not  by  automatons.  They  have,  or  ought  to  have, 
personal  interests  to  protect  in  the  stock  and  investment 
market.  No  matter  how  great  the  endeavor  to  keep  pri- 
marily in  mind  the  needs  of  the  public,  personal  responsibil- 
ities would  tend  always  to  create  an  unconscious  bias. 
Aloofness  from  the  stock  exchange  loan  market  is  not  an 
ideal  situation,  but  it  is  perhaps  the  price  that  must  be  paid 
to  limit  plutocratic  domination. 

On  purely  political  grounds,  Miss  Youngman's  pro- 
gramme is  unworkable.  Even  at  the  present  time,  when 
direct  advances  on  stock  exchange  security  are  impossible, 
there  is  a  widespread  belief  that  security  speculation  has 
benefited  more  largely  than  commerce  or  agriculture  from 
the  use  of  the  reserve  system's  funds.  The  insistence  upon 
an  agricultural  representative  upon  the  Federal  Reserve 
Board  is  one  indication  of  this  widespread  belief.  How 
much  greater  must  have  been  the  discontent  with  the 
reserve  management  if  direct  purchase  of  security  paper 


OPEN-MARKET  OPERATIONS  199 

had  been  permitted?  The  writer  is  convinced  that  the 
unpopularity  of  a  system  possessing  such  powers  would 
have  caused  a  complete  remodeling  of  the  system,  possibly 
to  the  detriment  of  all  classes,  in  the  agricultural  depression 
of  1920  and  192 1.  Political  considerations  are  quite  as  im- 
portant as  financial.  The  present  system  is  better  than  the 
old ;  too  much  should  not  be  expected  of  the  reserve  banks 
until  the  elementary  principles  of  finance  are  more  widely 
understood.  Development  cannot  be  too  rapid.  It  is  more 
desirable  that  slowly  but  soundly  foundations  be  built  for 
the  more  imposing  edifice  of  the  future. 

In  regard  to  the  inclusion  of  the  note  arising  from  com- 
mercial transactions  the  writer  will  agree  that  too  much 
attention  may  have  been  reposed  in  the  bankers'  accept- 
ance. But  the  trade  acceptance  arising  from  domestic 
operations  is  eligible  for  purchase.  In  the  past  the  popular- 
ization of  the  trade  acceptance  has  encountered  many 
obstacles.  But  part  of  the  difificulties  are  due  to  the  in- 
sistence that  its  progress  should  be  sound  rather  than 
merely  rapid.  It  might  be  better  at  the  present  time  to 
admit  the  promissory  note  to  open-market  dealings.  But 
many  dangers  would  lie  in  such  a  course,  and  it  appears  the 
part  of  wisdom  to  postpone  discussion  of  the  admission  of 
the  note  until  the  trade  acceptance  has  had  a  more  complete 
trial.  Many  will  hold,  furthermore,  that  the  abuses  of  the 
open  book-account  system  are  sufficient  to  warrant  some 
lessening  of  the  reserve  banks'  powers. 

Miss  Youngman's  proposals  arc  based  largely  upon  her 
doubts  as  to  the  efficacy  of  changes  in  rediscount  rates  to 
affect  general  money  charges.  In  many  localities  high  loan 
rates  will  persist  despite  any  lowering  of  reserve  banks' 
rates.  In  such  localities  banking  competition  may  \^ 
absent  and  the  high  charges  represent  some  degree  of 
monopolistic  extortion.   The  only  means  of  breaking  such 


200  FEDERAL  RESERVE  POLICY 

rates  lies  in  permitting  reserve  banks  to  step  in  as  competi- 
tors of  local  banks  by  their  direct  purchases.  But  such 
action  could  be  made  effective  only  by  permitting  dealings 
in  the  type  of  paper  customarily  employed.  Since  the  trade 
acceptance  is  unfitted  for  the  needs  of  many  buyers,  it  is 
argued  that  reserve  banks  should  be  permitted  to  purchase 
notes. 

Final  conclusion  upon  this  point  must  wait  upon  the  dis- 
cussion of  the  relation  of  reserve  banks'  rediscount  rates 
to  those  exacted  in  the  general  market.^  But  it  will  be 
generally  agreed,  perhaps,  that  as  a  matter  of  public  policy 
the  present  is  not  the  time  to  introduce  the  reserve  banks 
in  the  role  of  more  active  competitors  of  member  banks. 
Present  clamor  directed  against  the  reserve  system  is  suffi- 
ciently great  without  adding  this  new  source  of  discontent. 

During  the  World  War  a  situation  arose  which  led  Sen- 
ator Robert  L.  Owen,  then  Chairman  of  the  Senate  Banking 
and  Currency  Committee,  to  propose  the  establishment  of 
a  separate  reserve  bank  in  order  to  relieve  the  other 
reserve  banks  of  a  portion  of  their  responsibilities  under 
section  14  of  the  act.*  This  proposed  new  Federal  Re- 
serve bank  was  to  be  charged  with  the  responsibility  of  pre- 
venting the  dollar  exchange  from  depreciating^  abroad 
and  with  furnishing  American  commerce  with  the  credits 
required  in  foreign  transactions.  If  the  plan  which  he 
advocated  had  been  enacted  into  law,  the  regional  charac- 
ter of  our  reserve  system  would  have  been  altered  to  that 
extent.  His  bill  proposed  that  in  the  field  of  international 
credits  one  new  reserve  bank  should  serv^e  for  all  American 
industry  and  not  primarily  for  any  one  district. 

The  cause  of  Senator  Owen's  investigations  was  the 

'  See  infra,  pp.  339,  340. 

'  Cf.  H.  L.  Reed,  "Senator  Owen's  Proposal  to  Stabilize  Foreign  Exchange 
Rates,"  American  Economic  Review,  September,  1918,  pp.  661-69. 


OPEN-MARKET  OPERATIONS  201 

falling  of  the  dollar  below  its  normal  gold  par  in  some  of  the 
neutral  countries  of  Europe,  particularly  Spain,  Norway, 
Denmark,  Netherlands,  and  Sweden.  This  depreciation 
occurred  in  spite  of  the  fact  that  during  the  years  19 16  and 
19 1 7  the  United  States  possessed  a  favorable  trade  balance 
with  each  of  these  countries  as  well  as  with  the  world  at 
large.  But  credit  extended  by  the  United  States  to  its 
European  allies  resulted  in  a  plethora  of  dollar  credits  pos- 
sessed by  merchants  in  these  countries.  When  purchases 
were  made  from  Spain  by  England,  or  France,  payment  was 
frequently  made  by  drawing  upon  these  dollar  credits. 
Possessing  a  favorable  trade  balance  with  the  world  as  a 
whole,  Spain  acquired  more  dollar  credits  than  needed  to 
balance  its  own  requirements.  Since  shipments  of  gold 
were  suspended,  the  dollar  shrank  in  terms  of  pesetas. 

In  many  ways  this  depreciation  of  the  dollar  was  un- 
welcome. As  a  matter  of  first  importance,  perhaps,  it  was 
argued  that  it  rendered  somewhat  more  difficult  the  cam- 
paign to  assert  the  superiority  of  dollar  credit  as  a  medium 
of  international  payments.  The  supremacy  of  sterling  ex- 
change in  the  past  was  due  in  no  small  measure  to  its 
stability  in  terms  of  gold.  Here  was  the  opportunity  to 
establish  the  dollar  as  the  one  class  of  exchange  which  had 
not  depreciated  in  the  general  financial  confusion  engen- 
dered by  the  World  War.  Nevertheless,  for  the  reason 
given,  the  dollar  declined  in  terms  of  the  currencies  of  some 
of  the  countries  with  which  the  balance  of  trade  was  in  our 
favor. 

The  discount  on  the  dollar  abroad  also  increased  the  cost 
to  our  merchants  who  had  remittances  to  make  for  their 
imports.  A  premium  on  the  peseta  of  twenty-five  per  cent 
meant  that,  instead  of  the  dollar  buying  five  pesetas,  it 
bought  only  four.  But  aside  from  any  direct  material  loss 
the  psychological  effect  of  a  falling  dollar  was  held  not  to 


202  FEDERAL  RESERVE  POLICY 

be  good.  In  normal  situations  a  falling  exchange  points 
toward  future  gold  withdrawals.  The  dollar  exchange  has 
fallen  in  most  of  our  financial  crises.  Its  depreciation  dur- 
ing the  World  War  could  be  pointed  to  by  our  enemies  as 
evidence  of  our  financial  instability. 

Attempts  on  the  part  of  private  bankers  to  remedy  this 
difficulty  had  been  productive  of  little  benefit.  Private 
negotiations  for  the  necessary  loans  in  Spain  had  failed. 
Accordingly,  Senator  Owen  proposed  that  the  reserve 
banks  should  grapple  with  this  problem.  But  as  they  were 
then  constituted  they  lacked  the  machinery  and  powers 
necessary  to  secure  effective  results.  No  single  one  of  the 
reserve  banks  was  specified  by  the  statute  as  responsible 
for  the  maintenance  of  the  parity  of  the  American  dollar, 
and  it  would  be  impolitic  to  delegate  this  responsibility  to 
any  one.  Charges  of  sectional  discrimination  would 
inevitably  arise.  It  was  asserted,  furthermore,  that  each 
reserve  bank  was  already  so  completely  occupied  with 
matters  of  domestic  finance  that  it  could  not  give  the  prob- 
lem of  supplying  foreign  trade  with  the  credits  it  required 
the  necessary  attention. 

Senator  Owen  proposed,  accordingly,  that 

the  Federal  Reserve  Act  be  so  amended  as  to  provide  for  the 
establishment  of^a  Federal  Reserve  foreign  bank.^ 

This  bank  would  assume  the  responsibility  of  furnishing 
American  Commerce  with  a  stable  exchange.  It  would 
have  power  to  establish  foreign  branches  generously 
equipped  with  power  to  acquire  and  sell  foreign  credits.  If 
necessary  these  credits  could  be  established  in  foreign 
countries  by  the  sale  of  Government  bonds.  No  individual 

'  See  remarks  of  Hon.  Robert  L.  Owen  on  Senate  Bill  3928  to  establish  the 
Federal  Reserve  Foreign  Bank,  etc.,  in  the  Senate  of  the  United  States,  Febru- 
ary 25,  1918.  Cong.  Rec,  pp.  2817-825. 


OPEN-MARKET  OPERATIONS  203 

or  bank  other  than  this  foreign  bank  would  have  the  legal 
right  to 

sell  dollar  balances  at  less  than  gold  par,  except  as  payment 
for  merchandise  imported  into  the  United  States,  without  the 
express  authority  of  the  Federal  Reserve  Board. ^ 

It  would  be  directed  by  a  board  of  nine  men  appointed  by 
the  President  of  the  United  States,  and  all  of  these  would 
be  merchants  and  not  bankers.  Bankers  would  be  excluded 
from  the  directorate,  for 

Our  American  bankers  have  not  sufficiently  realized  that 
banking  grows  with  commerce  .  .  .  the  banker  who  thinks  in 
terms  of  interest  and  commission  and  profit  exaction  is  not 
happily  constituted  to  determine  the  best  methods  of  serving 
commerce. 

This  would  explain  why  reliance  could  not  be  placed  on 
the  recently  established  foreign  branches  of  private  banks. 
The  proposed  bank  would  be  a  reserve  bank.^ 

This  proposal  met  with  some  opposition  from  such  men 
as  Mr.  Harding,  and  Mr.  Warburg.  Mr.  Harding,  for  in- 
stance,^ felt  that  the  situation  was  not  sufficiently  serious 
to  justify  the  setting  up  of  such  elaborate  machinery  as  was 
called  for  by  Owen's  plan.  He  did  not  feel  that  the  tempo- 
rary dislocation  of  exchange  with  a  few  European  neutrals 
would  interfere  with  the  campaign  to  encourage  the  use  of 
the  dollar  exchange.  The  Orient  and  South  America  would 
not  be  affected  directly  by  the  discount  on  the  dollar  in 
these  European  nations,  and  it  was  in  the  Orient  and  South 
America  that  the  best  opportunity  existed  for  encouraging 
the  use  of  the  dollar  exchange.  The  continent  of  Europe 
would  probably  rcadopt  earlier  methods. 

'  Cong.  Rec,  pp.  2817-825. 

»  IbUl. 

» Bulletin,  August  i,  1918,  p.  724!!  . 


204  FEDERAL  RESERVE  POLICY 

The  rather  sudden  termination  of  hostilities,  bringing 
with  it  the  elimination  of  the  dollar  discount,  seemed  in  the 
minds  of  most  financiers  to  render  Owen's  machinery  un- 
necessary. If  the  plan  had  been  adopted,  however,  it  would 
have  marked  the  first  departure  from  the  regional  idea. 
The  writer  ventures  to  remark  that,  if  the  regional  plan  is 
to  be  altered  in  the  future,  the  opening  wedge  may  prove 
to  be  some  modification  of  the  open-market  powers.  It  is 
in  the  employment  of  these  powers  that  the  reserve  banks 
can  exercise  their  greatest  initiative  in  the  attempt  to  con- 
trol money-market  conditions. 


CHAPTER  X 
ADVANCES    OF    RESERVE    BANKS  — NOTE    ISSUES 

The  commercial  bank  creates  credit  or  credit  money  of 
two  forms,  note  issues  and  deposits.  Altliough  to-day  both 
in  Great  Britain  and  the  United  States  the  deposits  exceed 
note  issues  in  volume  and  importance,  early  banking  in 
both  countries  was  primarily  a  matter  of  issuing  notes.  It 
is  correct  in  the  main  to  state  that  modern  English  banking 
found  the  germ  of  its  development  in  the  evolution  of  the 
bank  note.  The  goldsmith's  receipt  of  the  fifteenth  and 
sixteenth  centuries,  supposedly  representing  a  value  in 
coin  or  bullion  equivalent  to  its  face,  gradually  was  adapted 
to  the  requirements  of  a  circulating  medium.  In  the  course 
of  time  it  was  made  payable  to  bearer  and  did  not  require 
endorsement  when  transferred  to  another  party.  It  came 
to  be  made  out  in  round  even  sums  instead  of  to  the 
amount  representing  the  deposit  of  the  owner.  When  ac- 
cepted by  the  public,  even  though  issued  to  an  amount 
exceeding  its  security,  the  trick  of  modem  commercial 
banking  had  been  learned. 

The  issuance  of  circulating  promises  to  pay  exceeding 
the  value  of  the  coin  or  bullion  security  subjects  the 
economic  world  to  many  dangers.  Excessive  issues  of 
bank  paper  currency  may  produce  the  same  results  as  the 
undue  issue  of  Government  paper  money.  The  price 
level  may  advance  rapidly  to  new  heights,  the  gold  of  the 
country  may  be  driven  out  as  a  consequence  of  the  adverse 
trade  balance  engendered  by  the  excessive  issues,  and  if 


206  FEDERAL  RESERVE  POLICY 

non-rcdecmable  an  important  element  in  the  currency  may 
depreciate.  For  these  reasons  attempts  to  restrict  its  issues 
would  be  expected.  It  might  be  argued,  however,  that 
unregulated  deposits  could  create  the  same  undesired  re- 
sults. However  this  may  be,  note  issues  were  developed 
before  deposits,  and  the  early  dangers  of  uncontrolled 
banking  were  attributed  largely  to  note  issues.  Accord- 
ingly, in  English  and  American  banking  law,  we  find  greater 
restrictions  imposed  upon  banks  in  their  note-issue  powers 
than  in  their  powers  to  create  book  credits  subject  to  check. 

It  may  be  that  the  discrimination  against  the  note  rests 
upon  a  sound  economic  basis.  The  note  is  payable  to  bearer 
and  possesses  a  greater  circulation  power  than  the  bank 
check.  It  may  circulate  for  a  considerable  period  far  from 
the  place  of  its  issue.  It  may  get  into  the  pocket  of  an  in- 
dividual who  has  no  opportunity  to  learn  of  the  solvency 
of  the  issuing  bank.  Because  of  its  tendency  to  stay  in 
circulation  longer,  the  ability  of  the  bank  which  issued  it 
to  redeem  is  not  so  speedily  tested  as  in  the  case  of  the  bank 
deposit.  Since  a  check  is  not  adapted  for  ccwitinuous  cir- 
culation, a  bank  is  automatically  restrained  from  issuing 
too  large  a  volume  of  deposit  credits.  So  large  an  amount 
of  checks  drawn  against  it  may  be  presented  to  the  clear- 
ing house  by  other  banks  that  a  deficit  in  cash  arises.  But 
if  the  issue  is  a  note,  some  time  may  elapse  before  the  issu- 
ing bank  is  called  upon  to  make  redemption.  The  penalty 
may  not  be  visited  so  speedily. 

At  any  rate,  either  because  of  these  considerations  or 
because  of  precedents  established  in  the  era  of  state  bank- 
ing, or  because  of  the  historical  fact  that  early  banking 
abuses  were  largely  note-issue  abuses,  the  framers  of  the 
National  Banking  Act  enacted  the  most  rigid  note-issue 
regulations.  As  finally  amended  the  law  rendered  it  im- 
possible for  national  banks  to  issue  notes  to  an  amount 


NOTE   ISSUES  207 

exceeding  the  par  or  market  value  of  Government  bonds, 
whichever  is  the  lowest,  deposited  with  the  Treasury  to 
secure  them.  Basing  note  issues  on  the  public  debt  made 
their  inelasticity  inevitable.  Their  volume  tended  to 
fluctuate  more  in  accordance  with  the  state  of  the  bond 
market  than  with  the  needs  of  trade.  Consequently  plans 
of  banking  reform  prior  to  the  panic  of  1907  usually  took 
the  direction  of  basing  note  issues  more  largely  upon  a 
wider  class  of  bank  assets.  Commercial  paper,  in  general, 
was  to  be  the  security  instead  of  Government  bonds.  And 
while  the  Aldrich-Vreeland  Act  evidenced  the  influence 
of  the  opponents  of  an  asset  currency,  provision  was  made 
for  the  issue  of  notes  in  periods  of  emergencies  collateraled 
by  a  wider  range  of  securities. 

Had  bank  note  issues  continued  to  occupy  their  old 
position  of  prominence  the  need  of  a  more  elastic  bank 
note  currency  would  have  been  uncontrovertible.  But 
since  the  date  of  the  writing  of  the  National  Bank  Act 
the  use  of  bank  deposits  has  become  relatively  much  more 
important.  At  the  present  time  it  is  estimated  that  the 
check  is  employed  as  a  means  of  payment  in  from  eighty- 
five  to  ninety  per  cent  of  our  total  transactions.  If  deposit 
credits  under  the  national  banking  system  had  possessed  a 
large  measure  of  elasticity,  it  would  have  been  logical  to 
attribute  our  currency  ills  primarily  to  the  bank  note. 
But,  largely  because  of  our  rigid  reser\'e  requirements,  de- 
posits also  were  insufficiently  elastic.  The  case  for  an  asset 
currency  was  not  quite  so  clear  as  it  otherwise  would  have 
been. 

These  facts  may  be  crudely  illustrated  by  noting  the 
customary  train  of  events  in  past  periods  preceding  general 
collapse.  As  reserve  ratios  fall,  banks  become  more  and 
more  hesitant  to  advance  needed  credits.  The  demand  for 
loans  becomes  all  the  more  intense  as  the  market  begins  to 


208  FEDERAL  RESERVE  POLICY 

decline.  By  the  time  general  public  confidence  is  disturbed, 
runs  upon  banks  may  ensue.  Since  these  runs  represent  a 
demand  for  currency,  the  inability  of  banks  to  expand 
their  bank  note  issues  freely  appears  to  constitute  the 
principal  weakness  of  the  banking  system.  But  would  the 
public  demand  for  cash  have  arisen  if  at  an  earlier  period 
banks  had  been  permitted  to  expand  their  grants  of  de- 
posit credits  in  the  necessary  amount? 

There  are  many  occasions  when  the  demand  upon  a 
particular  set  of  banks  is  primarily  a  demand  for  a  circulat- 
ing medium.  In  the  autumnal  season  of  harvesting  strain, 
crop-moving  expenses  could  not  be  met  by  expanding 
deposits  alone.  Checks  given  to  transient  laborers,  for 
instance,  would  be  presented  speedily  to  the  banks  for 
encashment.  An  enlargement  of  the  volume  of  bank 
currency  appeared  the  necessary  requirement.  But  if  re- 
serves against  deposits  had  been  less  rigid,  the  difficulties 
created  by  the  currency  demands  would  not  have  been  so 
intense.  The  currency  would  have  been  supplied  at  the 
expense  of  reserve  money,  but  the  penalty  of  slightly  im- 
paired reserves  would  not  have  been  so  great. 

By  the  time  the  Federal  Reserve  Act  was  written,  how- 
ever, these  facts  were  more  widely  accepted.  In  the  mind 
of  the  writer  the  principal  point  of  progress  marked  by  the 
Federal  Reserve  over  previous  plans  is  the  greater  recogni- 
tion of  the  need  of  elasticity  of  deposits.  A  thorough-going 
reform  plan  could  not  confine  itself  to  an  attempt  to  secure 
merely  an  asset  currency. 

It  was  agreed  nevertheless,  that  the  ideal  plan  of  reform 
would  secure  elasticity  in  bank  note  issues  as  well  as  in  de- 
posits. Bank  note  currency  provides  a  mesms  of  supplying 
the  public  with  a  circulating  medium  without  impairing  a 
bank's  supply  of  reser\''e  money.  Elastic  bank  note  issues  are 
part  of  the  problem  of  securing  more  flexible  deposit  credits. 


NOTE   ISSUES  209 

These  matters  of  elementary  banking  principle  granted, 
the  problem  of  banking  reform  became  that  of  determining 
what  set  of  banks  should  possess  the  bank  note  issue  re- 
sponsibility. Should  bank  notes  continue  to  be  issued  by 
the  member  banks  or  should  their  issue  be  concentrated  in 
the  hands  of  reserve  banks  only?  Bearing  in  mind  the  fact 
that  the  reform  movement  was  in  part  an  attempt  to  secure 
greater  concentration  in  credit  control,  it  is  not  surprising 
to  note  the  decision  to  concentrate  the  new  bank  note 
issuing  powers  in  the  hands  of  the  reserve  banks.  The  idea 
of  centralized  control  was  joined  to  that  of  greater  elastic- 
ity in  the  media  of  exchange. 

It  has  been  pointed  out  frequently  that  bank  note  issues 
are  not  absolutely  essential  to  central  bank  operation.  If 
its  power  to  control  credit  be  sufficient,  the  central  bank 
may  meet  the  demands  upon  it  by  accumulating  in  or- 
dinary times  a  surplus  supply  of  reserve  money  to  provide 
for  seasonal  or  emergency  needs.  It  is  probably  true,  how- 
ever, that  public  confidence  in  a  system  without  bank  note 
issue  powers  would  not  be  so  great.  Possessing  such  powers 
it  appears  as  if  the  central  bank's  ability  to  manufacture 
the  necessary  media  of  exchange  is  incapable  of  exhaustion. 
As  indicated  previously,  moreover,  the  general  public  has 
come  to  attach  an  exaggerated  importance  to  bank  note 
issues. 

But  what  should  be  done  with  the  old  bond-secured 
issues  of  national  banks?  There  was  much  to  offer  against 
any  programme  of  eliminating  or  subordinating  these 
issues.  They  constituted  a  definite  part  of  our  money  sup- 
ply approximating  $750,000,000  and  could  not  be  with- 
drawn immediately  without  subjecting  the  country  to  a 
money  famine.  Furthermore,  banks  had  purchased  the 
bonds  not  so  much  for  their  investment  yield  as  for  the 
security  of  their  bank  note  issues.  This  artifically  created 


210  FEDERAL  RESERVE  POLICY 

demand  caused  the  price  of  the  bonds  to  move  to  a  higher 
point  than  warranted  by  their  income  return.  Because  of 
the  circulation  privilege  attaching  to  its  bonds,  the  United 
States  has  been  able  to  borrow  money  at  cheaper  rates  than 
almost  any  other  country  in  the  world.  In  the  pre-war 
period,  while  the  United  States  two  per  cents,  bearing  the 
circulation  privilege,  were  selling  at  about  par,  British  two 
and  a  half  per  cent  consols  were  selling  only  slightly  above 
seventy,  and  French  three  per  cent  rentes  at  about  eighty- 
five.  Justice  demanded  that  the  Government  take  no  action 
confiscating  bond  values  bought  in  good  faith. 

In  order  to  reconcile  the  legitimate  interests  of  the  banks 
with  the  requirements  of  commerce  for  a  more  elastic 
currency  a  means  was  provided  by  the  act  for  the  gradual 
purchase  from  the  national  banks  of  a  portion  of  their 
bonds  by  the  Federal  Reserve  banks.  By  the  terms  of 
section  i8  any  member  bank  desiring  to  retire  any  of  its 
circulating  notes  is  permitted  to  "file  with  the  Treasurer 
of  the  United  States  an  application  to  sell  for  its  account, 
at  par  and  accrued  interest,  United  States  bonds  securing 
circulation  to  be  retired.  "  Such  applications  can  be  made 
in  the  twenty-year  period,  December,  19 15,  to  December, 
1935-  At  the  end  of  every  quarterly  period  the  Treasurer 
of  the  United  States  is  required  to  furnish  the  Federal 
Reserve  Board  with  a  list  of  such  applications.  The  Board 
may  require  the  reserve  banks  to  purchase  these  bonds, 
which  are  then  to  be  apportioned  among  the  twelve  reserve 
banks  pro  rata  according  to  their  relative  capital  and 
surplus.  It  w^as  provided  that  the  reserve  banks  could  not 
be  compelled  to  purchase  more  than  ^25,000,000  of  these 
bonds  in  any  one  year,  and  that  this  amount  must  include 
whatever  amount  of  bonds  the  reserve  banks  may  have 
purchased  directly  from  the  public  without  the  inter- 
vention of  the  Federal  Reserve  Board. 


NOTE   ISSUES  211 

In  this  manner  provision  was  made  for  the  eventual 
acquirement  by  the  reserve  banks  of  bonds  bearing  the 
circulation  privilege  and  the  gradual  retirement  of  the 
bank  notes  outstanding  against  them.  The  reserve  banks 
were  authorized  to  utilize  these  bonds  in  one  of  two  ways. 
First,  they  may  deposit  them  with  the  Treasurer  of  the 
United  States  and  upon  this  security  issue  bank  notes  to 
the  par  value  of  the  bonds.  The  law  stated  that  such 

notes  shall  be  the  obligations  of  the  Federal  reserve  bank 
procuring  the  same,  and  shall  be  in  form  prescribed  by  the 
Secretary  of  the  Treasury,  and  to  the  same  tenor  and  effect  as 
national-bank  notes  now  provided  by  law. 

In  case,  however,  no  vital  need  exists  for  this  currency, 
the  bonds  may  be  converted  into  one-year  gold  notes  or 
three  per  cent  thirty-year  old  bonds  not  possessing  the 
circulation  privilege.  Such  an  exchange  Is  to  be  made  on 
the  basis  of  par  and  accrued  interest.  If  this  method  is 
availed  of,  the  bond-secured  bank  notes  may  be  reduced 
gradually  in  volume.  But  this  reduction  may  be  very  slow, 
since  reserve  banks  cannot  be  required  to  purchase  more 
than  ^25,000,000  of  these  bonds  in  any  one  year.  But  at 
any  rate  provision  was  made  for  a  reduction  relative  to  the 
volume  of  other  currencies.  As  the  country  grows  in 
population  and  resources  and  the  other  elements  in  the 
circulation  increase,  the  bond-secured  bank  notes  will 
decline  in  importance. 

The  extent  to  which  the  reserve  banks  have  availed  of 

these  provisions  in  order  to  issue  their  own  bond-secured 

currency  is  indicated  for  certain  selected  dates  by  the 

following  figures: 

Federal  Reserve  Bank  Notes  in  Circulation 

Amount  Outstanding 

Jani!ar>' 4,  if)i8.  .    $     8.(X)0.ooo         Ucccnihcr  31,  lOiQ  ?273,450,8oo 

June  28,  1918.  .  .  .        10,390,000         December  31,  1920     249,467,000 

December  27,  1918     117,122,000        November  i,  1921      123,296,960 


212  FEDERAL  RESERVE  POLICY 

Without  further  information  it  might  appear  as  if  the 
reduction  in  national  bank  circulation,  particularly  in  the 
years  191 8  and  19 19,  must  have  been  exceedingly  heavy. 
This  would  seem  to  follow  from  the  fact  that  the  reserve 
bank  notes  were  required  to  be  secured  by  Government 
bonds,  and  that  the  surrender  of  these  bonds  to  the  reserve 
banks  must  compel  a  reduction  in  national  bank  currency.* 
But  the  figures  show  no  such  reduction  in  national  bank 
circulation.  At  the  close  of  192 1  it  was  approximately  the 
same  as  in  1914  and  had  increased  somewhat  since  1917. 
Thus: 

Total  Volume  of  National  Bank  Notes  Circulating  in  the 

United  States 
July  I,  1917.  .  .  $7i5;420,oio        January  i,  1919. .  $723,532,210 
January  I    1918     719,212,630         January  i,  1920. .     724,338,692 
July  I,  1918. . .     724,205,485         November  i,  1921     743,288,847 

Clearly  the  increase  in  the  volume  of  Federal  Reserve 
bank  notes  was  not  at  the  expense  of  the  aggregate  circu- 
lation of  national  bank  notes.  To  what,  then,  can  the  in- 
creased circulation  of  reserve  bank  notes  be  attributed? 

During  the  World  War  the  attention  of  Congress  was 
drawn  to  the  uses  which  might  be  made  of  the  stock  of 
silver  dollars  reposing  in  the  Treasury  of  the  United  States. 
Several  Oriental  countries  were  accumulating  balances 
against  the  United  States  and  our  allies  and  it  was  not  de- 
sired to  meet  these  claims  by  exporting  gold.  So  far  as 
silver  could  be  used  economically  for  this  purpose,  it  would 
seem  that  the  Treasury's  stock  should  be  drawn  upon. 
For  years  this  stock  had  been  lying  idle  as  the  metallic 
backing  for  the  silver  certificates. 

Accordingly,  by  the  Pittman  Act  of  April  23,  1918,  the 
Secretary  of  the  Treasury  was  authorized  to  melt  down 

'  Unless  offset  by  the  purchase  of  other  bonds  possessing  the  circulation 
privilege. 


NOTE   ISSUES  213 

and  sell  as  bullion  not  more  than  ^350,000,000  standard 
silver  dollars.  The  bullion  could  be  sold  for  the  following 
purposes:  first,  to  conserve  the  Nation's  stock  of  gold; 
secondly,  to  facilitate  with  silver-using  countries  the 
settlement  of  adverse  trade  balances;  thirdly,  to  provide 
silver  for  subsidiary  coinage  or  domestic  use.  In  order  to 
protect  the  silver  market  it  was  provided  that  the  bullion 
should  be  sold  at  a  price  of  not  less  than  ^i  per  ounce  of 
silver  1000  fine,  and  that  the  silver  thus  withdrawn  must 
be  repurchased  by  the  Treasury  at  the  same  price.  Since 
the  melting  down  of  the  silver  dollar  would  destroy  the 
security  for  the  silver  certificates,  it  was  provided  that 
these  certificates  should  be  retired  at  the  rate  of  ^i  for 
each  dollar  melted  down  or  broken  up. 

This  would  involve  a  reduction  in  one  of  the  elements 
in  our  currency.  In  order  to  prevent  a  corresponding 
contraction  in  the  general  circulating  medium  the  Federal 
Reserve  Board  was  given  authority  to  require  reserve 
banks  to  issue  Federal  Reserve  bank  notes  to  an  amount 
not  exceeding  the  amount  of  standard  silver  dollars  thus 
destroyed.  The  reserve  banks  issuing  these  were  required 
by  law  to  deposit  as  security  United  States  certificates  of 
indebtedness  or  one-year  United  States  gold  notes. 

The  amount  of  Federal  Reserve  notes  thus  issued  under 
the  terms  of  the  Pittman  Act  was  as  follows  on  certain 

dates: 

Up  to  AhfD 
Including 

December  31,  1918 $110,803,000 

December  31,  1919 259,375,000 

December  31,  1920 260,875,000 

The  Pittman  Act  was  regarded  merely  as  a  temporary 
measure.  Section  6  required  that,  as  the  silver  dollars  are 
recoined  through  the  purchase  of  silver  bullion  by  the 
Secretary  of  the  Treasury,  Federal  Reserve  bank  notes 


214  FEDERAL  RESERVE  POLICY 

shall  be  retired  in  an  amount  equal  to  the  volume  of  the 
dollars  so  coined.  Such  purchases  of  bullion  must  be 
made  at  the  rate  of  ^i  an  ounce.  On  April  i,  192 1,'  it  was 
announced  by  the  Secretary  of  the  Treasury  that  the  re- 
tirement of  Pittman  Act  certificates  had  been  begun  and 
would  be  continued  gradually. 

The  Pittman  Act  proved  decidedly  useful  during  the 
war  and  post-war  period.  It  seems  unfortunate,  however, 
that  the  Treasury  was  required  to  repurchase  the  amount 
of  silver  obtained  by  melting  down  the  dollars.  Securing 
silver  certificates  by  silver  coin  or  bullion  is  an  anomaly 
in  a  gold-standard  country.  The  real  security  for  any  of 
our  currency,  gold,  could  have  been  obtained  on  favorable 
terms  by  the  final  sale  of  the  silver  bullion  at  the  highest 
market  silver  has  commanded  in  years.  We  lost  our  oppor- 
tunity to  work  off  without  great  loss  our  silver,  the  exist- 
ence of  which  had  really  been  a  source  of  embarrassment  in 
previous  years.  But  it  may  have  been  politically  unwise 
to  estrange  the  silver  interests  during  the  period  of 
hostilities. 

But  no  progress  in  elasticity  was  made  by  the  issues 
of  Federal  Reserve  bank  notes.  It  was  by  the  means  of 
another  note  creation,  the  Federal  Reserve  note,  that  the 
endeavor  was  made  by  the  Act  of  1913  to  provide  the  truly 
elastic  element  in  our  currency  system.  These  notes  are 
the  issues  of  reserve  banks  upon  the  security  of  commercial 
paper,  and  each  note  bears  the  distinctive  number  of  the 
district  in  which  it  is  issued. 

By  the  terms  of  the  original  act  the  method  of  issue  was 
as  follows:  Any  reserve  bank  could  make  application  to 
the  Federal  Reserve  Agent — the  member  of  the  district 
directorate  who  is  the  official  representative  of  the  Federal 
Reserve  Board — for  such  amount  of  the  notes  as  it  may 
'  See  Bulletin,  April,  192 1,  p.  374. 


NOTE   ISSUES  215 

require.  Such  applications  must  be  accompanied  by  a 
tender  of  collateral  equal  to  the  amount  applied  for.  By 
the  original  act  the  collateral  offered  in  the  application 
must  be  notes  and  bills  accepted  by  the  reserv^e  bank  for 
rediscount.  But  the  act  was  later  amended  in  such  a  way 
as  to  include  in  the  collateral  paper  purchased  in  the  open 
market.  Section  16  now  states  that 

the  collateral  security  thus  offered  shall  be  notes,  drafts,  bills 
of  exchange,  or  acceptances  [acquired]  under  the  provisions 
of  section  thirteen  of  this  act,  or  bills  of  exchange  indorsed  by  a 
member  bank  of  any  Federal  reserve  district  and  purchased 
under  the  provisions  of  section  fourteen  of  this  Act,  or  bankers' 
acceptances  purchased  under  the  provisions  of  said  section  four- 
teen, or  gold  or  gold  certificates. 

The  Federal  Reserve  Board  can  at  any  time  call  upon  the 
reserve  bank  for  additional  security. 

These  notes  were  made  receivable  by  all  members  and 
reserve  banks.  They  are  obligations  of  the  United  States 
and  are  receivable  for  all  taxes.  They  are  not  legal  tender 
for  private  payments.  They  may  not  be  counted  as  a  part 
of  the  legal  reserve  of  a  member  bank.  Whether  or  not  they 
may  be  counted  as  reserve  money  by  a  State  bank  depends 
upon  law  in  that  State. 

The  first  line  of  security  behind  these  notes  is  the  com- 
mercial paper  (gold  in  lieu  of  paper)  deposited  with  the 
Federal  Reserve  agent.  Reserve  banks  must  also  main- 
tain a  forty  per  cent  gold  reserve  behind  these  notes.  This 
requirement,  however,  may  be  suspended  by  the  Federal 
Reserve  Board.  But  if  the  reserve  is  permitted  to  fall  below 
forty  per  cent,  a  graduated  tax  paid  by  the  reserve  bank 
will  operate  as  a  penalty. 

These  notes  will  be  issued  to  member  banks  through  the 
process  of  rediscount,  and  offer  a  means  whereby  reserve 
banks  can  supply  the  member  banks  with  counter  money 


2i6  FEDERAL  RESERVE  POLICY 

without  depleting  their  own  reserves.  Since  they  are 
issued  through  rediscounts,  prevention  of  excessive  issues 
becomes  a  part  of  the  problem  of  rediscount  policy.  Rate 
increases,  more  careful  scrutiny  of  the  paper  offered  by 
member  banks,  direct  refusals,  represent  the  means  of  pre- 
venting unduly  large  issuance  or  of  compelling  their 
retirement. 

But  what  means  were  provided  to  secure  their  speedy 
return  on  occasions  when  the  need  has  passed?  The  follow- 
ing devices  were  included  in  the  Federal  Reserve  Act. 
First,  the  notes  of  one  reserve  bank  may  not  be  paid  out 
by  another  reserve  bank  save  by  paying  as  a  penalty  a 
ten  per  cent  tax  upon  the  face  value  of  the  notes.  A  mem- 
ber bank  however,  located  within  or  without  the  district 
of  issue  may  pass  them  out  without  restriction.  Since  a 
Federal  Reserve  note  may  circulate  for  a  long  time  before 
being  deposited  with  a  reserve  bank,  this  provision  cannot 
be  expected  to  do  much  in  the  way  of  compelling  their 
quick  redemption.  Secondly,  the  notes  may  not  be 
counted  as  a  part  of  the  legal  reserves  of  any  member 
bank.  A  member  bank  in  need  of  reserve  money  will  be 
impelled,  therefore,  to  save  them  for  redemption.  But  on 
other  occasions  of  ample  reserves  member  banks  may  not 
find  it  necessary  to  establish  their  reserves  by  the  redis- 
count method.  In  this  situation  the  return  of  the  notes  is 
not  likely  to  be  rapid.  Finally,  the  notes  are  issued  only 
upon  the  deposit  with  the  reserve  agent  of  commercial 
paper.  If  the  reserve  banks  are  rediscounting  freely, 
ample  paper  should  be  available  to  replace  the  collateral 
upon  its  maturity.  But  if  the  reserve  banks  refuse  or  dis- 
courage renewals,  they  may  compel  member  banks  to 
return  the  notes  or  their  equivalent  in  other  currency. 

There  is  no  doubt  but  that  the  act  provides  ample 
means   for   redemption   in   cases   where   redemption   is 


NOTE  ISSUES  217 

desired.  They  must  be  received  by  any  member  bank  and 
by  any  reserv^e  bank;  if  they  reach  the  counter  of  another 
reserve  bank,  they  may  be  collected  either  directly  from 
the  reserve  bank  of  issue  or  indirectly  through  the  Gold 
Settlement  Fund  at  Washington.  But  while  there  is  an 
open  avenue  for  rapid  redemption,  nothing  short  of  a 
strict  rediscount  policy  is  likely  to  result  in  their  being 
driven  home  against  the  will  of  the  holder.  They  may  get 
into  the  vaults  of  State  banks  which  are  permitted  to 
count  them  as  reserve  money,  they  may  repose  in  the  tills 
of  merchants  or  pockets  of  the  people,  they  may  form  part 
of  the  counter  money  reserve  of  member  banks.  Only  one 
situation  is  likely  to  explain  their  return  against  the  will 
of  the  holder,  that  in  which  they  are  acquired  by  another 
reserve  bank  than  that  which  issued  them.  Expansion  of 
these  notes  in  time  of  need  is  easy,  but  whether  or  not 
there  is  to  be  contraction  in  slack  season  and  years  depends 
upon  the  rigor  with  which  the  reserve  management  exer- 
cises its  powers  of  rediscount  control. 

Mention  should  be  made,  however,  of  a  provision  in  the 
act  which  gave  the  Federal  Reserve  Board  power  to  exact 
from  the  reserve  bank  an  interest  charge  on  all  notes 
issued  to  the  reserve  bank  not  covered  by  gold  or  gold  cer- 
tificates in  the  hands  of  the  agent.  The  purpose  of  this 
provision  was  to  give  the  Board  some  power  in  the  way  of 
compelling  contraction.  Reserv^e  banks  compelled  to  meet 
such  a  charge  would  likely  exert,  by  means  of  higher  rates, 
pressure  upon  mc^aber  banks  to  return  the  notes  or  their 
equi\'alent  in  oth^money.  In  case,  however,  the  reser\'e 
bank  directorate  was  working  in  close  harmony  with  the 
Board,  ^^  did  not  endeavor  to  thwart  the  Board's  advice 
to  restfllr  rediscounts,  such  pressure  would  not  be  re- 
quired. The  writer  is  not  aware  that  a  tax  of  this  sort  has 
yet  been  imposed  upon  reserve  banks. 


2i8  FEDERAL  RESERVE  POLICY 

In  the  early  period  of  its  existence  the  volume  of  re- 
discounting  by  reserve  banks  was  exceedingly  limited. 
Nevertheless,  a  rather  large  amount  of  notes  got  into  cir- 
culation. Since  the  notes  are  issued  to  member  banks 
through  the  process  of  rediscounting,  the  public  was  at 
first  somewhat  puzzled  at  the  existence  of  so  large  an  out- 
standing circulation.  On  analysis,  however,  it  developed 
that  notes  once  issued  were  not  being  retired  upon  the 
maturity  of  the  paper  rediscounted.  Instead  of  returning 
the  notes  to  the  agent,  the  reserve  bank  would  deposit 
gold  as  "cover."  Reserve  banks,  when  called  upon  by 
member  banks  for  currency,  would  ofifer  the  Federal 
Reserve  notes  instead  of  gold.  In  this  way  the  notes  were 
becoming  virtually  gold  certificates. 

A  few  figures  will  indicate  the  extent  to  which  this  prac- 
tice was  carried  on.  On  July  2,  191 5,  the  total  amount  of 
notes  issued  to  the  reserve  banks  was  ^84, 000, 000.  As 
security  for  these  the  Federal  Reserve  agents  held  lawful 
money  to  the  amount  of  ^70,000, 000. v  On  June  30,  1916, 
the  amount  of  note  issues  was  ^176,000,000.  ^165,000,000 
of  the  cover  for  this  was  lawful  money.  On  June  29,  1917, 
^402,000,000  of  the  security  for  ^550,000,000  of  notes  was 
legal  tender  money.  In  other  words,  the  accumulation  of 
cash  in  the  hands  of  the  reserve  agents  was  chiefly  cash  and 
only  to  a  limited  extent  paper. 

This  policy  of  the  Federal  Reserve  Board  was  bitterly 
condemned  in  certain  quarters.  The  Commercial  aiid 
Financial  Chronicle,  for  instance,  ^erted  vigorously^ 
that  there  was  no  authority  for  keqflmg  the  notes  out- 
standing in  this  manner,  and  that  the  plain  intent  of  the 
law  was  to  secure  their  retirement  upon  the  maturity  of 
their  paper  collateral.  Furthermore,  the  ^Ptrd  was 
charged  with  usurpation  of  authority.  The  act  did  not  then 

'  Issue  of  August  7,  1915,  pp.  398-400. 


NOTE  ISSUES  219 

permit  notes  to  be  issued  to  reserve  banks  by  the  deposit 
of  gold  with  the  agent.  But  the  Board  was  accomplishing 
virtually  this  result  by,  first,  issuing  the  notes  on  commer- 
cial paper  security,  and  then,  upon  the  maturity  of  the 
paper,  making  gold  the  cover.  In  reality,  urged  the  Chron- 
icle, the  Board  was  breaking  the  spirit  of  the  law. 

Those  closely  connected  with  the  management  of  the 
reserve  system  did  not  hesitate  sharply  to  defend  this 
policy.  Governor  Strong,  of  the  New  York  Reserve  Bank, 
denied  vigorously  that  the  Board  was  exceeding  its 
authority.'  If  it  had  been  intended  that  the  notes  should 
represent  only  paper,  a  simple  provision  could  have  been  in- 
serted in  the  act  to  that  effect.  It  was  clearly  the  purpose 
of  the  act  that  the  notes  should  become  a  part  of  the  gen- 
eral circulation  and  the  policy  of  the  Board  was  designed 
merely  to  hasten  this  result.  Furthermore,  the  impound- 
ing of  gold  meant  no  inflation,  but,  on  the  contrary,  a 
restriction  of  bank  credit.  For  neither  by  reserve  banks 
nor  by  member  banks  could  the  notes  be  counted  as 
reserve  money. 

As  the  law  then  stood  there  can  be  little  question  as  to 
the  correctness  of  Governor  Strong's  views.  The  deposit 
of  gold  cover  with  the  reserve  agents  did  not  restrict  the 
possibilities  of  credit  expansion.  But  the  law  was  subse- 
quently amended  in  many  ways,  with  the  general  result 
of  increasing  the  ability  of  the  reserv^e  and  member  banks 
to  expand  their  deposits.  The  Chronicle  was  correct  in 
surmising  that  the  practice  of  impounding  gold  as  cover 
was  a  forerunner  of  many  later  events  the  general  trend  of 
which  was  to  alter  radically  the  working  of  the  system.  In 
the  development  of  these  plans  it  was  incidentally  neces- 
sary to  create  a  larger  fickl  for  the  circulation  <jf  the  notes. 

These  subsequent  events  will  be  discussed  in  the  folio w- 

•  Issue  of  August  7,  1915,  pp.  412-13. 


220  FEDERAL  RESERVE  POLICY 

ing  chapter.  They  can  be  treated  best  in  connection  with 
certain  amendments  altering  the  reserve  requirements  for 
member  banks  deposits.  To-day  the  Federal  Reserve  note 
is  the  most  important  element  in  our  general  circulation. 
Its  supremacy  over  other  moneys  can  be  noted  by  examin- 
ing the  following  figures:^ 

Money  Held  Outside  the  United    States  Treasury  and  the 
Federal  Reserve  System,  November  i,  192  i 
Gold  coin  (including  bullion)  .  .$    373,456,004 

Gold  certificates 189,141,549 

Standard  silver  dollars 38,837,297 

Silver  certificates 211,351,466 

Subsidiary  silver 259,176,773 

Treasury  notes  of  1890 1,554,164 

United  States  notes 265,413,018 

Federal  Reserve  notes 2,446,481,946 

Federal  Reserve  Bank  notes  .  .       102,363,172 
National  bank  notes 719,196,681 

At  the  present  time  the  national  bank  note  is  dwarfed 
by  the  Federal  Reserve  note.  Even  though  the  national 
bank  issues  aggregate  an  amount  somewhat  comparable 
to  that  of  19 14,  they  have  become  relatively  unimportant. 
Their  place  has  been  seized  by  the  new  Federal  Reserve 
note.  But  whether  or  not  the  new  note  is  to  be  truly 
elastic,  whether  or  not  it  is  to  display  the  qualities  of 
contractility,  is  dependent  mainly  upon  the  discount 
policy  adopted  by  the  Federal  Reserve  management. 

'Obtained  from  the  Bulletin,  December,  1921,  p.  1495. 


CHAPTER  XI 

ADVANCES  OF  RESERVE  BANKS— DEPOSITS  AND 
RESERVES 

In  the  preceding  chapter  it  was  remarked  that  the  move- 
ment in  this  country  for  banking  reform  took  first  the 
direction  of  attempts  to  secure  an  asset  currency.  The 
plan  formulated  by  the  American  Bankers'  Association 
in  1894,  known  as  the  Baltimore  plan,  may  be  interpreted, 
for  instance,  as  a  direct  attack  on  the  bond-security 
theory.  According  to  this  plan  it  was  proposed  to  permit 
the  issue  of  bank  notes  by  national  banks  secured  by 
commercial  assets.  Protection  for  the  noteholder  would 
consist  of:  first,  the  prior  lien  upon  the  assets  of  the  failed 
bank;  secondly,  restriction  of  bank  note  issues  to  a  certain 
percentage  of  the  capital  stock;  thirdly,  the  double  lia- 
bility of  stockholders.  The  plan  may  be  regarded,  there- 
fore, as  an  attempt  to  ensure  the  safety  of  the  bank  notes 
by  relying  upon  other  requirements  than  the  deposit  of 
Government  bonds.  But  it  disregarded  totally  the  prob- 
lem of  securing  a  more  elastic  deposit  currency. 

It  may  appear  as  if  a  similar  disregard  of  the  importance 
of  deposit  currency  was  displayed  in  the  Aid  rich- Vreeland 
Act  of  1908.  It  could  be  asserted,  for  instance,  that  the 
panic  of  1907  had  demonstrated  clearly  that  the  principal 
difficulty  of  our  banking  machinery  was  the  concentration 
of  the  reserves  of  the  interior  banks  in  New  York  City. 
Because  of  certain  misuses  of  these  funds  the  deposits 
could  not  be  withdrawn.  After  the  default  of  the  New 
York  depository  banks,  substitutes  for  money,  such  as 


222  FEDERAL  RESERVE  POLICY 

clearing  house  loan  certificates,  had  to  be  devised.  In 
many  localities  they  were  believed  to  have  brought  relief. 
What  was  accomplished  under  the  Aldrich-Vreeland  Act 
was  to  make  regular  provision  for  the  issue  of  emergency 
currency  under  the  regulation  of  the  Federal  Govern- 
ment. This  act  did  not  attempt  to  go  to  the  root  of  the 
difficulty.  It  contained  nothing  to  prevent  future  diffi- 
culties of  a  similar  sort  from  again  arising.  It  was  purely 
palliative  and  not  surgical. 

But  despite  its  apparent  necessity  the  matter  of  revising 
our  deposit  machinery  was  a  difficult  task.  It  would  seem 
to  involve  the  prohibition  of  the  employment  in  the  finan- 
cial centers  of  interior  bank  deposits  for  the  purpose  of 
supporting  stock  market  loans.  Plans  which  contemplated 
such  restrictions  must  arouse  a  great  deal  of  opposition. 
It  was  easier  to  confine  efforts  to  the  securing  of  an  asset 
currency.  Such  efforts  could  be  made  to  appear  solely  in 
the  light  of  concessions  to  the  banks.  They  would  be 
given  powers  which  previously  were  denied.  But  by  the 
time  of  the  Wilson  Administration  public  opinion  had 
crystallized  itself  more  definitely.  The  country  had  begun 
to  understand  that  any  reform  which  reached  the  roots  of 
previous  difficulties  must  do  something  more  than  merely 
to  provide  for  emergency  note  issues.  It  also  must  alter 
old  methods  relating  to  the  employment  of  bank  reser\^es. 

As  a  final  result  of  the  legislative  endeavors  culminating 
in  the  Federal  Reserve  Act,  four  leading  provisions  were 
enacted  regarding  the  reserves  of  member  banks.  First, 
it  was  stipulated  that  after  three  years  nothing  could  count 
as  reserve  for  any  member  bank  except  cash  in  its  own  vault 
or  deposits  with  the  reserv^e  bank  of  its  district.  This  did 
not  mean  that  member  banks  would  be  prohibited  from 
keeping  deposits  with  other  than  the  reser\-e  institutions. 
Banks  in  the  interior  could  continue  to  keep  deposits  with 


DEPOSITS  AND   RESER\'ES  223 

big  city  banks  in  any  amount  desired  for  purposes  of 
domestic  exchange  and  the  securing  of  whatever  interest 
such  deposits  would  command.  The  only  prohibition  of  the 
act  related  to  the  use  which  could  be  made  of  these  deposits. 
They  no  longer  could  be  counted  as  a  part  of  the  required 
legal  reserve  for  the  depository  banks.* 

Secondly,  the  act  reduced  considerably  the  amount  of 
the  reserve  percentages.  The  theory  accepted  was  that  with 
reserves  massed  in  central  reservoirs  the  same  protection 
could  be  furnished  the  depositor  with  a  smaller  amount  of 
reserve  money.  It  was  a  matter  of  realizing  the  economies 
of  reserve  concentration.  As  a  result  of  this  reduction  it  is 
estimated  that  in  19 14- 15  an  economy  of  four  or  five  hun- 
dred millions  of  dollars  was  effected. 

Thirdly,  it  was  provided  that  the  transfer  of  money  from 
private  correspondent  banks  in  the  central  reserve  cities 
to  the  Federal  Reserve  banks  might  be  gradual.  The  law 
stated  that  the  transfer  must  be  completed  within  three  years 
after  the  establishment  of  the  Federal  Reserve  bank  in  the 
district  in  which  the  bank  was  located.  A  specified  amount 
of  the  reserve  must  be  transferred  to  the  district  reserve 
bank  immediately,  another  specified  portion  at  the  end  of 
the  year,  and  later  installments  at  semiannual  intervals. 

The  purpose  of  these  provisions  was  to  effect  the  transfer 
of  reserves  without  subjecting  the  stock  market  to  a  sudden, 
severe  shock.  Banks  in  the  central  reserve  cities  were  to  be 
permitted  gradually  to  make  the  necessary  rearrangements 
in  their  loan  position.  It  was  hoped  that  some  progress 
might  be  made  in  establishing  the  custom  of  financing 
sharply  fluctuating  securities  by  time  instead  of  by  call  loans. 

Lastly,  the  act  stated  a  distinction  between  demand  de- 

'  Exception  could  be  made  to  this  statement  during  the  period  prior  to  the 
completion  of  the  process  of  transferring  reserve  money  from  central  reserve 
cities. 


224  FEDERAL  RESERVE  POLICY 

posits  and  time  deposits.  Deposits  subject  to  immediate  call 
necessarily  require  a  larger  reserve  than  those  withdrawable 
only  after  the  expiration  of  a  certain  period  of  time.  As  to 
the  distinction  between  demand  deposits  and  time  deposits 
a  paragraph  of  section  19  stated  that 

Demand  deposits  within  the  meaning  of  this  Act  shall  com- 
prise all  deposits  payable  within  thirty  days,  and  time  deposits 
shall  comprise  all  deposits  payable  after  thirty  days,  and  all 
savings  accounts  and  certificates  of  deposit  which  are  subject 
to  not  less  than  thirty  days'  notice  before  payment. 

These  reserve  requirements  for  member  banks  under  the 
original  act  may  be  represented  by  the  following  scheme : 

1.  Banks  in  the  Central  Reserve  Cities  (New  York,  Chicago,  St.  Louis). 

18  per  cent  demand  deposits  and  5  per  cent  time  deposits. 

(a)  In  own  vault  6-18. 

(b)  In  reserve  banks  of  its  district  7-18. 

(c)  Balance  optional  with  the  bank. 

2.  Banks  in  Reserve  Cities. 

15  per  cent  demand  deposits,  5  per  cent  time  deposits. 
(  (a)  5-15  in  own  vaults. 
After  three  years  •<  (b)  6-15  in  reserve  bank. 
(  (c)  Balance  optional. 

3.  Country  Banks. 

12  per  cent  demand  deposits,  5  per  cent  time  deposits, 
(a)  4-12  in  own  vault. 
(b    5-12  in  reserve  bank, 
(c)  Balance  optional. 

Four  methods  were  provided  by  which  deposits  could  be 
established  with  the  reserve  bank.  First,  lawful  money 
might  be  remitted.  Secondly,  checks  or  other  items  might 
be  forwarded  for  collection  to  the  reserve  bank.  (In  a  pre- 
ceding chapter  account  has  been  made  of  the  gradual  de- 
velopment of  this  work.  At  the  present  time  the  reserve 
banks  receive  for  collection  daily  an  enormous  volume 
of  cash  items  as  well  as  of  time  items.)  Thirdly,  commercial 
paper  might  be  rediscounted  according  to  the  terms  of  sec- 


DEPOSITS  AND   RESERVES  225 

tion  13.  Lastly,  certain  types  of  paper  or  securities  specified 
by  section  14  might  be  sold  directly  to  the  reserv^e  bank. 
But  how  far  could  the  reserve  banks  go  in  granting  mem- 
ber banks  book  credits?  This  would  depend  upon  the  vol- 
ume of  reserve  money  possessed  by  reserve  banks.  Section 
16  states  that 

Every  Federal  reserve  bank  shall  maintain  reserves  in  gold 
or  lawful  money  of  not  less  than  thirty-five  per  centum  against 
its  deposits.  .  .  . 

Since  the  establishment  of  the  reserve  system  the  mini- 
mum reserve  percentages  for  reserve  banks  have  been 
unchanged.  But  those  for  member  banks  have  been  altered. 
Let  us  next  endeavor  to  find  explanation  for  these 
alterations. 

Although  the  provisions  of  the  act  created  a  reduction  in 
the  aggregate  volume  of  reserves,  the  new  arrangements 
were  not  altogether  satisfactory  to  the  member  banks. 
Many  of  their  criticisms  were  unsound ;  nevertheless,  their 
general  effect  was  to  prepare  the  way  for  a  change.  The 
first  criticism  was  purely  the  result  of  a  misunderstanding. 
It  involved  the  belief  that  member  banks  would  not  be 
permitted  to  keep  deposits  in  banks  other  than  the  district 
reserve  banks.  This  view  was,  of  course,  erroneous.  The  act 
prohibited  only  the  counting  of  such  deposits  as  reserve 
money. 

Secondly,  it  was  asserted  frequently  that  in  reality  the 
act  increased  reserve  requirements.  Many  banks  argucil 
that  they  would  be  forced  for  exchange  or  other  purposes  to 
keep  deposits  with  city  correspondents  as  well  as  with  the 
reserve  banks.  The  two  deposits  combined  might  exceed 
those  customarily  maintained  under  the  old  law. 

Reply  to  this  was  that  since  the  reserve  banks  would 
make  collections  on  checks  and  other  items  and  credit  these 


226  FEDERAL  RESERVE  POLICY 

to  the  account  of  the  forwarding  bank,  deposits  in  other 
banks  for  collection  purposes  would  be  necessary  no  longer. 
In  the  beginning,  however,  there  was  some  doubt  as  to  how 
completely  the  reserve  banks  would  function  in  these  mat- 
ters. Would  the  reserve  banks  give  immediate  credit  for  the 
remittance  of  checks  drawn  against  non-member  State 
banks?  Would  they  collect  time  as  well  as  demand  items? 
Would  their  service  charge  be  unduly  high?  These,  at  first, 
were  matters  of  doubt.  Some  time  must  elapse  before 
reserve  banks  could  demonstrate  that  in  every  feasible 
way  they  would  endeavor  to  perform  the  services  previously 
rendered  by  the  correspondent  banks  of  the  financial  centers. 

But  even  though  reserve  banks  would  perform  these 
services,  they  could  not  pay  interest  on  deposits.  In  the 
past,  city  banks  were  willing  to  make  collections,  receive  at 
par  checks  drawn  against  the  bank,  as  well  as  pay  interest 
on  the  balance.  The  reserve  banks  would  pay  no  interest. 

This  objection,  however,  overlooked  the  savings  effected 
through  the  reduction  in  the  amount  of  the  reserve  required. 
Suppose,  for  instance,  that  the  country  bank  had  outstand- 
ing before  the  establishment  of  the  new  system  ^100,000  of 
demand  deposits.  The  minimum  reserve  for  this  would  be 
^15,000.  Three  fifths  of  this  amount,  or  ^9000,  might  be 
carried  as  a  balance  with  its  city  correspondent.  The  year's 
interest  on  this  amount  at  2  per  cent  would  be  ^180.  This 
appeared  to  be  a  direct  loss. 

But  under  the  new  arrangement  the  required  reserve 
would  be  ?i2,ooo  instead  of  ^9000,  or  a  saving  of  ^3000.  If 
this  could  be  invested  to  realize  6  per  cent,  the  interest  would 
cancel  entirely  the  apparent  loss  of  ^180. 

In  the  matter  of  the  "float, "  finally  some  member  banks 
felt  themselves  harshly  treated.  In  an  early  chapter  men- 
tion was  made  of  the  loose  practices  formerly  permitted  by 
the  Comptroller  according  to  which  country  banks  could 


DEPOSITS  AND   RESERVES  227 

establish  reserves.  Checks  drawn  against  outside  banks 
would  be  dispatched  to  the  city  correspondents  and  im- 
mediately considered  as  reserve  money.  Under  the  clearing 
plan  finally  worked  out  by  the  Reserve  Board,  distantly 
drawn  checks  would  not  be  credited  to  the  account  of  the 
forwarding  bank  until  sufficient  time  had  elapsed  in  which 
to  make  collections.  Despite  the  logic  and  the  necessity  of 
this  practice,  many  banks  asserted  that  they  were  being 
harshly  treated. 

Whether  or  not  these  complaints  alone  would  have  se- 
cured any  concessions  for  member  banks  cannot  be  as- 
certained definitely.  But  it  happened  that  the  plans  of  the 
reserve  administration  were  such  as  to  lend  its  influence  to 
the  lowering  of  reserve  minima.  The  endeavor  of  the  admin- 
istration was  to  devise  a  means  of  gaining  control  of  a  larger 
portion  of  the  country's  gold.  The  natural  method  of  accom- 
plishing this  result  would  be  to  require  member  banks  to 
keep  a  larger  portion  of  their  reserves  with  reser\'e  banks 
than  that  law  at  first  compelled.  But  it  was  understood  that 
this  could  be  brought  about  only  by  lessening  the  amount 
which  must  be  kept  in  the  banks'  own  vaults.  Since  it  was 
felt  that  the  concentration  of  reserve  money  under  the 
control  of  reserve  banks  would  be  a  more  economical  use  of 
reserve  money,  the  final  outcome  was  a  reduction  in  the 
aggregate  legal  minima. 

It  is  easy  to  understand  the  importance  ascribed  by  the 
reserve  management  to  the  accomplishment  of  the  purpose 
of  accumulating  the  Nation's  gold  more  largely  in  the  vaults 
of  reserve  banks.  Such  gold  would  form  the  basis  for  a  much 
larger  issue  of  Federal  Reserve  notes  or  of  book  credits  to 
member  banks.  The  war  in  Europe  resulted  in  an  enormous 
inflow  of  gold  to  America  and  there  was  no  assurance  that 
after  the  war  there  would  not  be  an  outflow  of  similar  pro- 
portions.   In  order  to  guarantee  our  ability  to  meet  any 


228  FEDERAL  RESERVE  POLICY 

post-war  demands,  it  would  be  desirable  to  have  it  under 
the  control  of  the  Board,  which  was  supposed  to  keep  the 
general  public  needs  foremost  in  mind.  Then  again  the 
disregard  of  neutral  rights  had  gone  so  far  in  the  European 
conflict  that  it  was  not  at  all  certain  whether  the  United 
States  could  continue  to  assume  an  inactive  role.  If  war 
should  come,  the  demands  upon  our  banks  would  be  heavy. 
A  much  greater  expansion  of  credits  would  be  possible  if 
the  gold  was  lodged  in  reserve  banks'  vaults. 

As  expressive  of  the  views  of  one  member  of  the  Federal 
Reserve  Board  the  following  remarks  may  be  quoted  from 
an  address  of  Paul  M.  Warburg:^ 

We  are  faced  with  the  simple  question:  Will  we  be  strong 
enough  to  share  our  plenty,  during  the  coming  period  of  stress, 
with  other  nations  and  be  the  world's  banker,  or  will  we  be  so 
weak  that,  when  these  demands  come,  we  must  stop  them  at 
once  by  raising  our  discount  rates  high  enough  to  retain  our  gold 
at  home?  Keep  all  the  gold  in  your  vaults,  gentlemen,  where  it 
is  useless  for  yourselves  and  deprived  of  the  additional  force  that 
it  may  gain  in  the  hands  of  the  federal  reserve  banks ;  keep  every 
cash  till  in  hotels,  railroad  stations,  dry  goods  stores  and  what 
not,  filled  with  gold  certificates,  and  you  will  rob  the  country 
of  its  legitimate  opportunity  of  growth,  of  helping  itself,  and 
of  helping  the  world.  Our  foreign  competitors  will  proclaim  that 
only  a  country  willing  to  part  freely  with  its  gold  may  safely 
be  accepted  as  a  world's  banker,  and  they  will  point  to  the  fact 
that  in  past  critical  periods,  our  banks  stopped  paying  in  gold. 
It  is  our  duty  to  give  the  world  an  overwhelming  evidence  of  our 
ability  and  determination  in  the  future  to  maintain  our  gold 
obligations  under  any  and  all  circumstances. 

A  discussion  of  the  measures  employed  by  the  reserv^e 
administration  to  accomplish  this  purpose  forms  one  of  the 

'  Delivered  before  the  American  Bankers'  Association  at  Kansas  City.  See 
Journal  of  the  American  Bankers'  Association,  October,  1916,  pp.  307-19.  Cf. 
also  address  by  A.  C.  Miller,  another  member  of  the  Board,  delivered  before 
the  Indiana  Bankers'  Association.  Jbid.,  November,  1916,  pp.  385-90. 


DEPOSITS  AND   RESERVES  229 

most  interesting  chapters  in  financial  history.  At  the  incep- 
tion of  the  new  system,  it  was  not  clear  what  machinery 
could  be  employed  to  bring  under  the  Board's  control  any 
large  amounts  of  gold.  The  act  required  member  banks* 
to  make  payments  for  their  capital  stock  subscriptions  in 
gold.  Member  banks  must  also  keep  a  portion  of  their 
reserves  with  reserve  banks,  but  the  final  transfer  of  re- 
serves from  reserve  or  central  reserve  cities  would  not  be 
completed  for  three  years.  These  reserves  might  be  estab- 
lished partially,  moreover,  by  rediscounts  and  not  the 
remittance  of  specie.  Altogether  these  measures  would 
bring  the  reserve  banks  only  a  small  portion  of  the  Nation's 
gold.  Accordingly,  the  ingenuity  of  the  Board  hit  upon  the 
previously  mentioned  device  ^  of  impounding  gold  as  cover 
for  note  issues.  By  this  means  a  large  quantity  of  gold  was 
got  into  the  hands  of  the  reserve  agents.  But  this  gold  was 
immobile.  It  must  remain  as  collateral  for  the  Federal 
Reserve  notes,  and  could  not  be  employed  to  support  further 
issues  of  notes  or  deposit  credits  extended  by  reserve  banks. 
But  for  the  time  being  the  Board  was  obliged  to  confine 
its  efforts  to  the  substitution  in  the  general  circulation  of 
Federal  Reserve  notes  for  gold,  and  to  the  accumulation 
of  this  gold  in  the  hands  of  the  agents.  In  this  connection  it 
is  interesting  to  read  a  letter  sent  by  the  Board  on  Septem- 
ber 1 1 ,  1916,  to  the  various  district  banks.  It  had  developed 
that  one  of  the  reserve  banks  had  been  meeting  the  currency 
requirements  of  its  members  by  shipments  of  gold  certifi- 
cates. Gold  certificates  could  be  obtainc^l  a  little  more 
cheaply  than  the  Federal  Reserve  notes.  Section  16  states 
that 

The  plates  and  dies  to  be  procured  by  the  Comptroller  of  the 
Currency  for  the  printing  of  such  circulating  notes  shall  remain 

'Section  2. 

»  See  supra.  Chapter  X,  pp.  217-219. 


230  FEDERAL  RESERVE  POLICY 

under  his  control  and  direction,  and  the  expenses  necessarily 
incurred  in  executing  the  laws  relating  to  the  procuring  of  such 
notes,  and  all  other  expenses  incidental  to  their  issue  and  retire- 
ment, shall  be  paid  by  the  Federal  reserve  banks  .    .    . 

The  Board,  however,  requested  the  reserve  banks  to  ignore 
their  desire  to  save  a  small  expense  and  to  issue,  instccid, 
whenever  possible  Federal  Reserve  notes, 

thereby  helping  to  concentrate  gold  certificates  in  the  vaults  of 
the  Federal  Reserve  banks.' 

But  to  what  extent  would  member  banks  be  willing  to 
receive  Federal  Reserve  notes?  If  their  need  was  for  re- 
serve money,  they  could  return  the  notes  to  the  reserve 
bank  and  demand  redemption.  But  for  counter  money 
purposes  the  notes  would  be  as  good  a  currency  as  any. 
They  would  be  acceptable  also  by  such  State  banks  as  were 
permitted  to  count  them  as  reserve  money. 

Nevertheless,  there  were  limits  to  the  willingness  of  mem- 
ber banks  to  absorb  the  notes.  They  would  not  be  ac- 
ceptable when  held  in  excess  of  the  amount  necessary  for 
till  money  and  when  legal  reserves  were  low.  Accordingly 
the  Board  began  to  move  for  changes  in  the  act  which  would 
create  a  wider  field  for  the  Federal  Reserve  note  circulation. 
It  proposed  an  amendment  which  would  permit  reserve 
banks  to  issue  Federal  Reserve  notes  directly  against  the 
deposit  of  gold  with  the  Federal  Reserve  agents.  This  sug- 
gestion was  rejected  by  Congress  together  with  another 
proposal  that  the  Federal  Reserve  notes  should  be  made 
legal  reserve  money  for  member  banks.  But  in  the  amend- 
ments of  September  7,  19 16,  it  was  enacted  that 

Upon  the  afifirmative  vote  of  not  less  than  five  of  its  members 
the  Federal  Reserve  Board  shall  have  power,  from  time  to  time, 
by  general  ruling  covering  all  districts  alike,  to  permit  member 

« Btdletin,  October  i,  1916,  p.  512. 


DEPOSITS  AND   RESERVES  231 

banks  to  carry  in  the  Federal  Reserve  Banks  of  their  respective 
districts  any  portion  of  their  reserves  now  required  by  section 
nineteen  of  this  Act  to  be  held  in  their  own  vaults. 

The  Board  ruled  immediately  (September  8,  19 16)  *  that  un- 
til further  notice 

any  member  bank  so  desiring  shall  be  permitted  to  carry  in  the 
Federal  Reserve  Bank  of  its  district  any  portion  of  its  reserves 
now  required  by  law  to  be  held  in  its  own  vaults. 

This  amendment  did  much  to  increase  the  willingness  of 
country  member  banks  to  transfer  their  deposits  from  city 
reserve  agents  to  reserve  banks.  It  tended  also  to  render  the 
Federal  Reserve  notes  more  acceptable.  A  meml^er  bank 
possessing  a  sufficient  amount  of  credits  on  the  books  of  its 
reserve  bank  need  not  worry  about  the  kind  of  money  in  its 
own  vaults.  For  counter-money  purposes  the  notes  were 
as  good  as  gold. 

But  helpful  as  this  amendment  was,  its  accomplishments 
were  negative  so  far  as  rendering  any  outright  advantage 
to  member  banks  was  concerned.  Shifting  reserves  to  re- 
serve banks  would  not  increase  the  member  bank's  loaning 
power.  If  the  member  bank  did  not  heed  the  Board's  implor- 
ations,  it  would  not  be  subject  to  penalty.  Accordingly,  the 
Board  pressed  for  a  change  in  the  law  which  would  make 
compulsory  what  previously  had  depended  entirely  on  the 
discretion  of  the  member  bank.  Success  crowned  its  efforts 
by  the  enactment  of  the  amendment  of  June  21,  1917.  This 
amendment  stated  that  thereafter  member  banks  must  hold 
their  legal  reserves  entirely  on  deposit  with  reserve  banks. 
The  only  legal  reserve  would  be  credits  on  the  books  of  the 
reserve  banks.  Of  course  the  member  bank  would  be  ob- 
liged to  keep  on  hand  a  supply  of  money  for  payments  over 
the  counter.  But  the  amount  of  this  till  money  would 
depend  upon  the  discretion  of  the  member  bank. 

^Bulletin,  October  i,  1916,  p.  508. 


232  FEDERAL  RESERVE  POLICY 

According  to  one  of  the  Board's  earlier  suggestions  to 
Congress,  the  percentage  of  till-money  reserve  would  be 
definitely  stated  by  law.  Leaving  the  matter  entirely  to  the 
discretion  of  the  member  bank,  therefore,  may  be  regarded 
as  a  step  toward  the  abolishment  of  the  rigid  reserve  require- 
ments of  the  earlier  days. 

There  has  been  a  disposition  on  the  part  of  some  banks 
to  insist  that  this  amendment  increased  rather  than  de- 
creased the  real  reserves  required  of  member  banks.  This 
argument  was  based  upon  the  fact  that  the  requirements  of 
the  new  law  made  no  mention  of  till  money.  Whatever 
amounts  must  be  kept  for  payments  over  the  counter  must 
be  added  to  the  legal  requirements.  But  even  with  this 
addition  the  writer's  investigations  lead  him  to  believe  that 
for  all  the  banks  of  the  country  there  was  a  considerable 
reduction.  At  any  rate,  as  will  shortly  be  explained,  the  abil- 
ity of  reserve  banks  to  rediscount  for  member  banks  was 
increased  by  this  measure  enormously.  Member  banks 
establish  reserves  by  rediscounting.  They  were  benefited 
by  the  terms  of  this  amendment. 

The  percentage  of  member  banks'  net  deposits  which 
must  be  held  as  credits  with  the  reserve  banks  has  been  as 
follows  since  the  amendment  of  June  21,  19 17. 

FOR  DEMAND  DEPOSITS  FOR  TIME  DEPOSITS 

Banks  in  central  reserve  cities  ..13  3 

Banks  in  reserve  cities lo  3 

Banks  in  all  other  cities 7  3 

In  the  opinion  of  the  writer  this  amendment  is  by  far  the 
most  important  which  has  been  superimposed  upon  the 
original  act.  Occurring  shortly  after  our  entrance  into  the 
World  War,  it  rendered  absolutely  certain  the  ability  of  our 
banks,  for  the  time  being  at  least,  to  guarantee  the  success 
of  the  Treasury's  bond  sales.  It  made  possible  a  pyramid- 
ing of  credits  unexampled  in  the  history  of  banking.    It 


DEPOSITS  AND   RESERVES  233 

contained  great  possibilities  of  good  as  well  as  of  evil.  The 
expansion  of  credit  which  has  taken  place  since  19 17  is  in 
large  measure  due  to  the  working  of  the  amendment  of 
June,  1917. 

Let  us  now  endeavor  to  explain  how  efficient  gold  in  the 
possession  of  reserve  banks  has  become  in  furnishing  a 
basis  for  member  banks'  deposit  credit  advances  to  the 
business  public.  First,  let  us  view  the  situation  from  the 
standpoint  of  the  country  bank.  Taking  into  account  only 
demand  deposits  and  assuming  no  till  money  to  be  neces- 
sary, ^24.50  of  lawful  money  in  the  possession  of  the  re- 
serve bank  would  permit  a  country  bank  to  extend  ^looo 
of  deposit  credits  to  its  clients.  The  ^24.50  would  be  the 
35  per  cent  reserve  for  the  ^70  of  book  credits  granted  by 
the  reserv^e  bank  to  the  member  bank.  This  ^70  would  be 
the  member  bank's  7  per  cent  reserve  for  ?iooo  deposits 
granted  one  of  its  customers.  In  other  words,  a  dollar  of 
legal  tender  currency  lodged  in  the  vaults  of  a  reserve 
bank  would  enable  a  country  bank  to  loan  more  than  ^40 
of  deposit  credits. 

This  same  sort  of  pyramiding  of  reserves  existed  under 
the  old  national  banking  system.  But  then  the  utmost 
that  could  be  done  was  to  enable  the  country  bank  to  loan 
313  for  a  dollar  of  reserve  money  lodged  in  the  vaults  of  a 
central  reser\'e  city  bank.  The  old  reserve  percentage  for 
country  banks  was  ^1000.  Fifteen  per  cent  of  ^1000  = 
^150,  Of  this,  ^90  might  be  held  as  a  deposit  with  a  re- 
serve city  bank  whose  minimum  reserve  was  25  per  cent. 
Twenty-five  per  cent  of  ^90  =  ^22.50.  Half  of  this  ^22.50, 
or  ^11.25,  might  be  held  as  a  deposit  credit  on  the  b(X)ks 
of  a  central  reserve  city  bank  which  must  keep  a  straight 
25  per  cent  reserve.  Twenty-five  per  cent  of  ^11.25  is 
^2.81 ;  $60  plus  $11.25  pl^i^  ^52. 81  is  ^574. 06;  ^luoo  divided 
by  ^74.06  is  13  plus. 


234  FEDERAL  RESERVE  POLICY 

Let  us  now  view  the  situation  from  the  standpoint  of 
the  reserve  city  bank.  Under  the  old  system  pyramiding 
of  reserves  could  go  to  a  point  where  ^looo  of  its  deposit 
could  be  backed  by  ^156.25.  The  reserve  city  bank's  25 
per  cent  reserve  for  ^1000  is  ^250.  Half  of  this  might  be 
kept  in  the  form  of  a  deposit  with  a  central  reserve  city 
bank  whose  reserve  must  be  25  per  cent.  Twenty-five  per 
cent  of  ^125  =  ^31.25;  ^31.25  plus  ^125  =  ^156.25.  In 
other  words,  the  real  reserve  minimum  was  15.6  per  cent. 

After  the  amendment,  however,  the  actual  reserve  for 
this  class  of  banks  need  be  only  3.5  per  cent;  10/100  of 
^1000  of  35/100  =  ^35.  In  central  reserve  city  banks  a 
straight  25  per  cent  reserve  was  required.  Now  it  need  be 
only  4.55  per  cent;  13/100  of  ^1000  of  35/100=^45.50. 

Some  allowance,  however,  should  be  made  for  the  mem- 
ber bank's  till-money  requirements.  Let  us  assume  that  a 
counter-money  reserve  of  5  per  cent  would  be  sufficient, 
and  that  this  be  composed  entirely  of  Federal  Reserve 
notes.  Behind  these  notes  the  reserve  bank  must  keep  a 
40  per  cent  gold  reserve.  Forty  per  cent  of  5  per  cent  is  2 
per  cent.  Two  per  cent,  therefore,  should  be  added  to  the 
percentages  given  above. 

But,  even  after  making  this  addition,  it  will  be  per- 
ceived that  a  dollar  of  gold  or  lawful  money  in  the  posses- 
sion of  the  reserve  bank  was  rendered  extremely  efficient 
in  supporting  member  bank  advances.  Our  reserve  mech- 
anism after  June,  1921,  was  very  similar  to  the  English 
system  wherein  the  reserves  of  private  banks  consist 
largely  of  credits  on  the  books  of  the  Bank  of  England. 
But  the  English  custom  was  the  result  of  a  long  and  slow 
development.  Never  before  was  a  currency  measure 
enacted  which  enabled  banks  on  the  moment  to  multiply 
so  enormously  their  grants  of  credit  to  the  business  public. 

Not  only  was  gold  becoming  more  efficient  as  reserve 


DEPOSITS  AND   RESERVES  235 

money,  but  the  inflow  of  gold  to  this  country  prior  to  the 
amendment  had  been  enormous.  In  a  few  years  the  net 
inflow  was  more  than  a  billion  dollars.  If  this  gold  could 
be  got  into  the  reservoirs  of  the  reserve  system,  the  power 
of  the  new  system  would  be  established  once  for  all.  Here 
was  an  opportunity  of  centuries  and  the  reserve  manage- 
ment did  not  overlook  it.  In  every  possible  way  the  en- 
deavor was  made  to  substitute  notes  for  gold  certificates 
in  the  general  circulation,  and  to  accumulate  the  gold  in 
the  reserve  banks'  vaults. 

One  difficulty  in  accomplishing  this  purpose  resulted 
from  the  fact  that  the  Federal  Reserve  notes  could  not  be 
issued  in  sufficiently  small  denominations.  The  act 
limited  these  issues  to  denominations  of  ^5  and  above.  It 
was  impossible  under  these  circumstances  to  keep  the 
notes  circulating  in  as  large  a  volume  as  otheru'ise  might 
be  accomplished.  When  the  need  was  for  money  in  small 
denominations,  the  Federal  Reserve  notes  would  be  pre- 
sented for  redemption.  The  problem  was  thus  to  over- 
come the  difficulty  created  by  the  large  denominations 
of  the  notes. 

Partial  solution  for  this  difficulty,  however,  was  found 
by  an  act  passed  on  October  5,  1917,  which  was  designed 
to  create  a  larger  field  for  the  circulation  of  the  notes.  To 
quote  the  Bulletin  on  this  matter:  * 

The  passage  of  the  act  of  October  5,  1917,  authorizing  national 
banks  to  issue  not  more  than  $25,000  each  in  denominations  of 
$1  and  $2  and  authorizing  them  to  issue  notes  of  $5  on  the  same 
basis  as  other  denominations  is  intended  to  provide  a  larger 
volume  of  small  bills.  The  Treasury  Department,  as  is  well 
known,  has  for  some  time  past  been  converting  large  green- 
backs or  United  States  notes  into  notes  of  small  denominations, 
thereby  probably  finding  a  permanent  field  of  circulation  for 
them.  As  the  greenbacks  thus  move  out  of  the  larger  and  into 
^BuUelin,  November  i,  1917,  pp.  833-34. 


236  FEDERAL  RESERVE  POLICY 

the  small  denominations,  an  increasing  field  for  Federal  Reserve 
notes  is  opened.  The  Treasury,  Federal  Reserve  Board,  and 
the  Federal  Reserve  Banks  are  consistently  cooperating  in 
substituting  Federal  Reserve  notes  for  the  circulation  of  gold 
certificates,  and  they  are  effectively  supported  in  this  under- 
taking by  the  national  banks  and  those  of  the  State  banks  and 
trust  companies  which  have  joined  the  system. 

Various  other  devices  were  being  employed  in  the  mean- 
while to  discourage  the  issuance  of  gold  into  the  general 
circulation.  By  the  fall  of  191 7  the  banking  law  of  New 
York  State  had  been  amended  so  as  to  permit  State  banks 
and  trust  companies  to  count  Federal  Reserve  notes  as 
part  of  their  vault  reserves.*  In  the  securing  of  such 
statutes  various  associations  of  bankers  played  an  impor- 
tant r61e.  April  10,  1917,  the  executive  committee  of 
the  American  Bankers'  Association  at  a  meeting  in  New 
York  resolved : ' 

That  this  committee  urgently  recommends  to  the  trust  com- 
panies of  the  United  States  that  immediate  steps  be  taken  to 
secure  amendments,  where  necessary,  to  the  State  laws  in  order 
that  the  trust  companies  may  be  permitted  to  carry  their  gold 
reserves  on  deposit  with  the  Federal  Reserve  Banks  in  their 
several  districts,  and  that  as  soon  as  such  action  can  be  legally 
taken,  the  trust  companies  offer  to  deposit  these  reserves  with 
the  Federal  Reserve  Banks. 

In  its  issue  of  January  29, 19 19,  the  Chicago  Tribune  con- 
tained an  announcement  of  the  position  of  the  Subtreasury 
of  Chicago  and  the  Federal  Reserve  bank  of  that  city.  It 
was  stated  that  the  Federal  Reserve  notes  bear  the  words : 

This  note  is  redeemable  in  gold,  on  demand,  at  the  Treasury 
Department  of  the  United  States  in  the  City  of  Washington, 
or  in  gold  or  lawful  money  ^  at  any  Federal  Reserve  Bank. 

Accordingly,  the  Subtreasury  and  the  bank  were  within 

'Cf.  Commercial  and  Financial  Chronicle,  August  25,  1917,  pp.  760-61. 
»See  Bulletin,  May  I,  1917,  p.  335. 
» Italics  are  the  writer's. 


DEPOSITS  AND  RESERVES  237 

their  legal  rights  in  suggesting  that  the  party  who  wanted 
gold  could  go  to  Washington  to  get  it.  They  announced 
that  they  themselves  would  not  pay  out  a  single  gold  coin 
for  any  purpose  whatsoever. 

By  such  methods  as  these  the  reserve  notes  were  made 
to  take  the  place  in  the  general  circulation  of  the  legal 
tenders  so  that  the  latter  could  be  available  for  the  re- 
serves of  reserve  banks.  But  prior  to  June  21,  19 17,  the 
law  relating  to  the  collateral  securing  reserve  notes  was 
such  as  to  limit  the  possibilities  of  substituting  notes  for 
gold.  When  the  collateral  originally  securing  Federal 
Reserve  notes  matured,  gold  would  be  deposited  with  the 
Federal  Reserve  agent,  and  the  notes  would  be  retained 
for  reissue  to  the  member  banks.  This  gold  coukl  not  be 
counted  as  a  part  of  the  reserve  for  deposits.  Accordingly, 
the  effectiveness  of  the  policy  of  impounding  gold  as  cover 
for  the  notes  was  limited. 

This  difficulty  was  lessened,  however,  by  the  amend- 
ment of  June  21,  1917,  which  paved  the  way  for  a  still 
greater  expansion  of  bank  credits.  Prior  to  this  amend- 
ment, money  deposited  with  the  Federal  Reserve  agent 
as  cover  for  the  notes  could  not  be  counted  as  part  of  the 
reserve  for  deposits.  But  after  this  amendment,  gold 
deposited  with  the  agent  as  security  for  the  reserve  notes 
could  be  counted  as  a  part  of  the  reserve  bank's  40  per 
cent  gold  reserve  for  notes.  This  would  enable  other  gold, 
which  previously  had  been  earmarked  as  the  note  reserve, 
to  support  a  larger  volume  of  book  credits  granted  to 
member  banks.  The  limit  was  further  removed  within 
which  note  issues  might  restrict  reserve  banks'  power  to 
create  money  deposits  for  member  banks. 

By  such  legal  and  administrative  measures  the  reserve 
management  had  answered  with  finality  the  question  of 
its  future  power  and  influence.  The  gold  holdings  of 
reserve  banks  became  steadily  larger,  and  more  and  more 


238  FEDERAL  RESERVE  POLICY 

banks  became  members  of  the  system.  The  expansive 
power  of  our  credit  structure  was  increased  wonderfully. 
In  later  chapters  figures  will  be  given  regarding  the 
amount  of  increase  in  credit  advances  to  member  banks 
rendered  possible  by  these  measures.*  But  enough  has 
been  presented  to  indicate  that,  as  a  result  of  the  admin- 
istrative and  legal  changes  culminating  in  the  amendment 
of  June  21,  191 7,  the  working  of  the  reserve  system  was 
altered  definitely. 

One  or  two  matters  of  banking  technique  may  now  be 
considered  briefly.  The  first  relates  to  the  method  of 
computing  member  banks'  reserve  percentages.  Specifi- 
cally, what  was  the  law's  definition  of  net  deposits  to 
which  the  reserve  percentages  applied?  To  answer  this 
we  can  do  no  better  than  to  quote  from  an  Opinion  of 
Counsel  in  the  Law  Department  in  the  Bulletin :  * 

Member  banks,  in  determining  the  amount  against  which 
reserves  must  be  carried,  may  deduct  all  Government  deposits, 
except  postal  savings'  deposits,^  and  may  deduct  from  the 
amount  of  balances  due  to  other  banks  the  amount  of  balances 
due  from  bank  checks  drawn  on  banks  located  in  the  same  place 
and  exchanges  for  clearing  houses.  The  law,  however,  does  not 
permit  member  banks  to  deduct  checks  on  other  banks  located 
in  the  same  place  or  exchanges  for  clearing  houses  from  gross 
demand  deposits,  nor  does  it  permit  cash  on  hand  to  be  deducted 
from  gross  demand  deposits. 

In  a  later  chapter  certain  information  will  be  given 
regarding  the  determination  of  the  reserve  banks'  reserves 
for  deposits  granted  member  banks. 

'See  infra,  Chapter  XIV.  ^Bulletin,  September  i,  1917,  p.  692. 

^Bulletin,  June  i,  1917,  p.  458.  This  exemption  of  Government  deposits  was 
the  result  of  an  act  approved  April  24,  19 17.  While  the  prime  purpose  was  to 
assist  in  financing  the  war,  the  law  referred  to  all  Government  moneys  and  not 
merely  to  the  proceeds  of  bond  sales.  The  purpxjse  was  in  part  to  enable  the 
Treasury  to  keep  as  long  as  possible,  to  the  advantage  of  the  local  banks,  funds 
in  the  localities  which  supplied  them. 


CHAPTER  XII 

FEDERAL   RESERVE    DEVELOPMENT,    NOVEMBER, 
1914,  TO  DECEMBER,  1916 

In  each  of  the  preceding  chapters  attention  has  been 
focused  upon  some  one  aspect  of  Federal  Reserve  opera- 
tion. The  problems  confronting  the  reserve  management 
cannot  be  well  presented,  however,  by  employing  this 
method  alone.  It  is  necessary  that  we  understand  the 
relation  of  each  project  to  the  others  in  the  gradual  devel- 
opment of  Federal  Reserve  policy.  For  this  purpose  we 
have  divided  the  life  of  the  reserve  system  into  four 
periods.  The  first  period,  extending  from  November, 
1 9 14,  to  December,  191 6,  was  primarily  one  of  organiza- 
tion-development and  preparation  for  future  emergencies. 
The  second  period,  January,  1917,  to  May,  191 7,  is  char- 
acterized chiefly  by  two  facts.  First,  the  reserve  banks 
by  their  discount  and  purchase  operations  were  beginning 
to  secure  some  degree  of  effective  control  over  the  money 
market;  and,  secondly,  the  reserve  system  was  being  made 
ready  to  bear  the  financial  strain  of  the  war  that  began  to 
appear  more  and  more  imminent.  In  the  third  pcricxl, 
June  I,  19 1 7,  to  November  11,  191 8,  the  management  was 
absorbed  in  the  task  of  cooperating  with  the  Treasury  in 
meeting  the  problems  of  war  finance.  The  fourth  period, 
extending  from  the  armistice  to  the  spring  of  1920,  may 
be  characterized  as  that  of  post-war  credit  and  trade 
expansion.  The  final  period  concerns  the  relation  of  the 
reserve  system  to  business  and  industry  in  the  depression 
of  1920-21. 


240  FEDERAL  RESERVE  POLICY 

The  Federal  Reserve  Act  became  law  December  23, 
19 1 3.  It  provided  for  the  appointment  of  an  Organization 
Committee  composed  of  the  Secretary  of  the  Treasury, 
the  Secretary  of  Agriculture,  and  the  Comptroller  of  the 
Currency.  Among  this  committee's  duties  was  the  map- 
ping out  of  the  country  into  the  various  districts,  each  to 
be  served  by  a  reserve  bank.  After  this  work  was  com- 
pleted, the  committee  served  notice  upon  the  national 
banks  of  the  country  to  subscribe  to  the  capital  stock  of 
the  new  banks.  As  soon  as  a  sufficient  amount  of  capital 
was  guaranteed  in  this  way,  the  formalities  were  begun 
of  granting  corporate  life  to  the  reserve  banks  and  pro- 
ceeding with  the  election  of  directors  for  the  district 
boards.  In  the  meanwhile  the  President  was  engaged  in  the 
task  of  appointing  the  members  of  the  Federal  Reserve 
Board.  In  this  some  delay  was  encountered.  President 
Wilson  had  announced  that  in  the  selection  of  the  Board 
he  did  not  wish  suggestions  of  the  sort  usually  offered  in 
the  making  of  appointments.  He  appeared  to  be  convinced 
that  the  selection  of  a  strong  personnel  was  of  the  utmost 
importance  to  the  Nation.  But  after  his  nominations  were 
made,  some  further  delay  was  caused  by  the  action  of  the 
Senatorial  Banking  Committee  in  holding  up,  on  the 
ground  of  their  business  affiliations,  the  appointments  of 
Mr.  Warburg  and  Mr.  Jones.  Mr.  Warburg  refused  to 
submit  to  cross-examination  by  the  committee.  His  nomi- 
nation, however,  eventually  was  confirmed." 

In  these  ways  the  spring  and  summer  of  19 14  slipped  by, 
and  it  seemed  that  the  opening  of  the  reserve  banks  for 
business  must  be  postponed  until  the  spring  of  1915.  But 
in  the  meanwhile  the  European  conflict  broke  out,  creating 
such  financial  disturbances  as  to  cause  to  be  reconsidered 
the  question  of  the  date  of  operation. 
*  Cf.,  Commercial  and  Financiai  Chronicle,  July  11,  1914,  pp.  91-92. 


DEVELOPMENT,  NOV.,  1914,  TO  DEC,  1916      241 

The  nature  of  the  upset  to  the  Nation's  finances 
created  by  the  sudden  outbreak  of  hostilities  is  now  thor- 
oughly familiar  to  the  general  public.  In  a  very  brief 
period  European  security  exchanges  were  closed  and  New 
York  became  the  world's  dumping  ground  for  a  great  mass 
of  internationally  owned  securities.  This  sudden  selling 
pressure  induced  such  weakness  in  the  securities  market 
that  to  prevent  the  collapse  of  bank  credit  exceptional 
action  was  taken.  New  York  followed  the  lead  of  Paris 
and  London  and  closed  to  trading  the  country's  leading 
securities  exchange. 

In  a  number  of  ways  this  upset  in  stock  market  circles 
occurred  at  a  very  inopportune  time.  A  large  block  of 
New  York  City  Subway  notes  held  by  foreign  capitalists 
was  about  to  mature,  and,  moreover,  there  had  been  the 
usual  drawing  of  finance  bills  in  the  pre-autumnal  period 
to  provide  a  portion  of  the  funds  for  the  moving  of  the 
crops.  The  expectation  was  that  these  bills  would  be 
covered  out  of  the  proceeds  of  agricultural  exports  sub- 
sequent to  the  fall  harvesting  period. 

For  the  time  being,  however,  there  was  a  virtual  stop- 
page in  the  export  trade  and  a  cessation  of  active  trading 
in  some  of  the  leading  articles  of  commerce.  Some  time 
was  required  for  the  English  and  French  navies  to  clear 
the  sea  lanes  of  German  raiders,  and  it  was  understood 
that  foreign  countries  must  economize  wherever  possible 
in  the  consumption  of  American  products.  Food  prociucts 
were  necessaries,  however,  and  it  is  interesting  to  note  that 
throughout  the  emergency  the  Produce  Exchange  of 
New  York  as  well  as  the  grain  exchanges  remained  open 
and  did  an  enormous  business.  It  was  perceived  that  the 
European  purchase  of  food  products  could  not  long  l^e 
postponed.  But  the  leading  product  of  an  entire  section 
of  the  country,  cotton,  could  not  be  moved,  and  its  price 


242  FEDERAL  RESERVE  POLICY 

declined  in  a  very  brief  period  from  twelve  or  thirteen  to 
seven  or  eight  cents  a  pound.  No  basic  article  of  agricultural 
production  is  financed  more  largely  by  credit  than  cotton. 

Under  these  circumstances  all  sorts  of  plans  were 
conceived  to  relieve  the  strain  upon  the  Southern  banks. 
The  "Buy-a-Bale-of-Cotton"  movement  was  launched  and 
projects  were  formulated  involving  loans  upon  cotton 
evaluated  by  semi -governmental  agencies  at  prices  higher 
than  existing  quotations.  These  plans  came  to  naught, 
but  Northern  Bankers  were  induced  to  pool  their  resources 
by  organizing  a  cotton  loan  fund. 

Gold  could  not  be  shipped  until  the  sea  lanes  were  made 
safe,  and,  moreover,  there  was  displayed  a  general  dis- 
inclination of  American  bankers  to  let  gold  go  out  of  the 
country.  With  the  cessation  of  gold  shipments  sterling 
exchange  moved  far  above  the  normal  export  point. 

It  was  felt  generally  that  these  adverse  conditions  could 
not  continue  indefinitely.  It  was  expected  that  European 
demand  for  cotton  must  finally  renew  itself,  the  resump- 
tion of  export  selling  would  lessen  the  demand  upon  our 
gold,  the  quieting  of  conditions  in  European  financial 
centers  would  lessen  the  likelihood  of  reckless  security 
dumping  and  make  safe  the  opening  of  our  exchanges. 
But  despite  this  undercurrent  of  confidence  the  shock  was 
of  almost  unprecedented  severity.  It  is  generally  believed 
that  the  banking  system  of  1907  would  have  succumbed 
quickly  in  this  crisis. 

Fortunately  the  Aid  rich- Vreeland  Act  was  available  to 
provide  legal  sanction  for  the  issuance  of  bank  notes 
secured  by  other  collateral  than  Government  bonds.  It 
will  be  recalled  that  the  terms  of  this  act  were  such  as  to 
permit  of  these  notes  being  issued  without  much  formality. 
Banks  were  empowered  to  organize  into  associations  and 
the  issues  would  be  protected  by  the  collective  collateral 


DEVELOPMENT,  NOV.,  1914,  TO  DEC.  1916     243 

of  the  association.  In  August  the  act  was  amended  by 
Congress  in  such  a  way  as  to  enable  the  issuance  of  these 
bank  notes  to  a  larger  proportion  of  the  banks'  capital 
than  at  first  authorized.  Altogether  something  like 
^380,000,000  of  emergency  currency  notes  were  put  out.* 
In  many  of  our  cities  also  large  volumes  of  clearing  house 
certificates  were  issued.  As  additional  measure  of  relief 
the  Secretary  of  the  Treasury  adopted  some  rather 
extraordinary  measures.  Mr.  McAdoo  took  the  position 
that  in  a  situation  so  grave,  a  situation,  moreover,  in 
which  the  provision  for  emergency  issues  existed,  no  bank 
was  justified  in  refusing  legitimate  demands  of  its  cus- 
tomers for  credit.  Consequently,  publication  was  begun 
of  a  so-called  blacklist  in  which  were  stated  the  names  of 
banks  whose  reserves  were  extraordinarily  large.  Possibly 
because  of  the  aid  rendered  by  such  measures  the  credit 
stringency  was  prevented  from  becoming  acute. 

It  was  undoubtedly  unfortunate  that  the  reserve 
system  was  not  in  operation  at  the  time  of  the  crisis.  It 
provided  for  a  reduction  in  reserves  somewhat  comparable 
to  the  total  amount  of  Aid  rich- Vreeland  notes  and  clearing 
house  certificates  issued.*  With  its  note-issuing  powers 
there  would  have  been  little  doubt  of  its  ability  to  meet  all 
legitimate  demands.  With  the  reserve  banks  operating, 
many  of  the  emergency  measures,  such  as  the  Cotton 
Loan  Pool  and  the  Foreign  Exchange  Fund,  would  have 
been  unnecessary.  If  the  stock  exchange  could  have  been 
kept  open,  our  willingness  to  pick  up  at  bargain  prices  the 
securities  of  frightened  European  holders  would  have  been 

'  Cf.  Report  of  the  Federal  Reserve  Board,  1914,  p.  15. 

'According  to  figures  based  upon  the  Comptroller's  call  of  September  12,  the 
reduction  would  be  $464,919,076.  This  makes  no  allowance,  however,  for  the 
duplication  and  triplication  of  items  under  the  old  law.  The  real  cash  reduction 
would  be  considerably  less.  Vice-frtivernor  Delano's  estimate  of  the  actual 
reduction  was  S25u,o<x),(xx).  (Cf.  Comincrcial  ami  Fi)uituial  ChronicU,  Novem- 
ber 21,  1914,  p.  i486.)   But  at  any  rate  the  psychological  effect  was  good. 


244  FEDERAL  RESERVE  POLICY 

one  of  the  strongest  indications  of  our  financial  power.  If 
gold  exports  could  have  been  maintained  freely,  Withers* 
would  not  have  found  opportunity  for  chiding  New  York 
at  becoming  panic-stricken  at  her  first  opportunity  of 
supplanting  London  as  the  world's  banker.  He  would  not 
have  been  able  to  assert  that  a  temporary  little  difficulty 
in  Lombard  Street  threw  Wall  Street  into  utter  confusion. 
The  reserve  banks  could  have  furnished  all  the  relief  of 
the  emergency  measures  without  outward  confession  of 
the  existence  of  strain. 

It  was  felt,  however,  that  it  would  be  a  mistake  to  begin 
the  operation  of  the  reserve  banks  until  its  organization 
was  more  complete.  Inability  to  function  properly  might 
lessen  permanently  the  prestige  of  the  new  system.  Some 
difficult  readjustments,  moreover,  would  be  occasioned 
by  its  establishment.  For  one  matter,  the  transfer  of 
reserve  funds  from  the  banks  of  the  central  reserve  cities 
to  the  Federal  Reserve  banks  might  create  some  acuteness 
in  the  financial  centers.  But  in  a  short  period  financial 
conditions  became  less  disturbing.  By  the  end  of  August 
it  was  noted  that  the  emergency  currency  notes  were 
being  returned  in  large  quantities  and  there  was  less  dis- 
cussion of  plans  involving  the  valorization  of  cotton. 
Money  rates  in  the  financial  centers  began  to  ease,  and  on 
the  last  Saturday  of  October  the  New  York  Clearing 
House  report  showed  that  the  reserve  deficiency  which 
had  existed  since  the  outbreak  of  the  European  war  had 
been  replaced  by  a  substantial  cash  surplus.  The  demand 
for  funds,  moreover,  began  to  lessen  under  the  influence 
of  reduced  speculative  activity  in  the  stock  market. 
Accordingly,  toward  the  close  of  October  the  Secretary 
of  the  Treasury  announced  that  all  of  the  twelve  reserve 
banks  would  begin  operation  November  i6. 

»  Cf.  Hartley  Withers,  War  and  Lombard  Street,  pp.  98-1 11. 


DEVELOPMENT,  NOV.,  1914,  TO  DEC,  1916     245 

The  time  of  their  opening  was  thus  synchronized  with 
the  restoration  of  activity  in  the  export  trade.  Accord- 
ingly, the  return  to  normal  conditions  was  rapid.  The 
first  week  in  December  tradings  under  a  minimum  price 
were  resumed  in  the  New  York  Stock  Exchange,  and 
shortly  thereafter  all  restrictions  were  removed.  The 
emergency  issues  continued  to  come  in  for  redemption. 

In  the  haste  to  get  the  reserve  banks  into  operation 
they  were  not  equipped  at  first  with  full  power.  The  Board 
was  able  to  issue  regulations  covering  only  such  operations 
as  were  deemed  essential  to  their  functioning  with  reason- 
able efficiency.  In  Circular  No.  13  addressed  to  all  the 
Federal  Reserve  agents  on  November  10,'  the  Board 
confined  its  recommendations  to  discount  operations. 
Open-market  dealings  were  to  be  reserved  for  slow  devel- 
opment, and  no  attempt  was  to  be  made  for  the  time  being 
to  establish  a  unified  system  of  clearances. 

The  discount  demands  upon  the  banks  immediately 
after  opening  were  light,  however,  and  the  administra- 
tion's efforts  were  confined  largely  to  developing  the 
internal  organizations  of  the  banks  and  to  the  determina- 
tion of  certain  broader  questions  of  policy.  The  most 
important  of  the  latter  was  this:  What  should  be  the  nor- 
mal place  of  the  reserve  banks  in  our  financial  structure? 
Should  they  be  continuously  in  the  market,  or  should  they 
husband  their  resources  for  use  primarily  in  emergencies? 
There  were  many  at  that  time  who  stressed  the  emergency 
character  of  the  machinery.  It  was  the  outgrowth,  it  was 
held,  of  the  movement  for  banking  reform  which  first 
reached  greatest  proportions  in  the  framing  of  the  Aid  rich 
plan.  In  that  project,  avowedly,  the  new  machinery  in 
large  degree  was  designed  for  emergency  operation. 
Except  on  occasion  of  financial  disturbance  the  National 

•Cf./?cpor<  of  the  Federal  Reserve  Board,  19 14,  p.  9. 


246  FEDERAL  RESERVE  POLICY 

Reserve  Association's  activities  would  be  limited.  But  in 
period  of  credit  strain  it  would  offer  its  notes  to  the  stock- 
holding banks. 

It  was  also  argued  that  the  permanent  functioning  of 
the  reserve  machinery  must  mean  undue  competition 
with  the  member  banks.  It  was  insisted  that  its  rediscount 
rate  should  normally  be  higher  than  the  general  money 
rate.  If  not,  its  funds  would  be  used  to  the  profit  of  the 
banks  which  rediscounted  their  paper,  and  the  resources 
of  the  system,  derived  from  the  contributions  of  all  the 
banks,  would  be  unavailable  in  time  of  disturbance. 
Partiality  in  the  distribution  of  its  funds  must  not  be 
permitted.  In  this  vein  writes  C.  W.  Barron  in  his  book 
on  the  Federal  Reserve  Act.   He  states :  * 

If  the  new  Federal  Reserve  Board  is  of  the  desired  quality 
and  character  it  will  be  the  most  unpopular  board  that  ever  sat 
in  Washington.  It  will  turn  deaf  ears  to  all  political  and  sec- 
tional considerations.  The  greater  the  clamor  for  cheap  money 
the  tighter  it  will  hold^the  reserves  within  or  without  the  coun- 
try. It  will  keep  watchful  eye  upon  every  section  to  see  that 
banking  facilities  for  cornering  potatoes  in  Maine,  or  cotton 
in  Texas;  lumber  in  Oregon  or  the  Carolinas,  corn  in  Illinois,  or 
wheat  in  Kansas  or  Minnesota,  are  absolutely  not  furnished 
by  any  part  of  the  reserve  system  over  which  the  board  presides. 

To  follow  out  this  argument,  the  only  means  of  avoiding 
sectional  partiality  is  to  remain  absolutely  aloof  from  the 
money  market  except  on  occasion  of  great  need. 

In  a  somewhat  similar  manner  argued  Mr.  Arthur 
Reynolds,  then  President  of  the  American  Bankers'  Asso- 
ciation, in  an  address  delivered  on  June  27,  1914.  He 
regretted  that  every  line  of  the  Reserve  Act  contained  an 
invitation  to  rediscount.  He  feared  over-expansion  of 
credit  if  this  invitation  was  generally  accepted.' 

'  Page  13. 

»  See  Commercial  and  Financial  Chronicle,  July  4,  19 14,  p.  20. 


DEVELOPMENT,  NOV.,  1914,  TO  DEC,  1916    247 

A  similar  view  was  also  the  editorial  expression  of  the 
Commercial  and  Financial  Chronicle.  To  quote  one  sen- 
tence of  their  statement:^ 

The  point  which  should  not  escape  attention  is  that  the  re- 
serves having  been  passed  over  to  the  keeping  of  the  Federal 
Reserve  banks,  the  member  banks  no  longer  have  any  control 
over  them,  and  yet  they  are  the  property  of  the  member  banks 
and  their  character  has  not  been  changed;  they  are  still  the 
reserves  of  these  member  banks. 

Consequently  they  should   not   be  dissipated  except  on 
occasion  of  intense  need. 

These  views,  however,  failed  to  commend  themselves 
to  the  reserve  management.  Unless  the  reserve  banks 
should  get  into  the  market,  their  earnings  would  be  small. 
Earnings  were  held  to  be  necessary  to  pay  the  operating 
expenses  of  the  reserve  banks,  to  yield  a  dividend  on  the 
stock  subscriptions,  to  finance  internal  developments,  and 
to  maintain  the  prestige  of  the  banks  in  the  eyes  of  the 
public.  It  was  argued  that  the  resources  of  the  reserve 
banks,  if  employed  sparingly  and  wisely,  need  not  become 
unavailable  for  the  member  banks.  They  could  be  in- 
vested mainly  in  such  short-time  liquid  investments  as 
could  be  convertible  into  cash  without  difficulty  upon 
occasion  of  need. 

Time  and  experience  [it  was  stated]  will  show  what  the 
seasonal  variations  in  the  credit  demands  and  faclHties  in  each 
of  the  Reserve  Banks  of  the  several  districts  will  be  and  when 
and  to  what  extent  a  Reserve  Bank  may,  without  violating  its 
special  function  as  a  guardian  of  banking  reserves,  engage  io 
banking  and  credit  operations.' 

The  relation  between  earnings  and  prestige  was  stated 

'  Commercial  and  Financial  Chronicle,  January  30,  19 15,  pp.  334-35. 
'  Cf.  Report  of  the  Federal  Reserve  Board,  UJ14,  p.  18. 


248  FEDERAL  RESERVE  POLICY 

as  follows  in  one  of  the  annual  reports  of  the  Federal 
Reserve  Bank  of  San  Francisco:* 

While  there  seems  no  economic  defense  for  an  effort  under 
existing  conditions  to  employ  a  Federal  Reserve  bank's  funds 
for  the  purpose  of  earning  profit,  yet  what  may  be  called  the 
psychological  importance  of  reasonable  earnings  seems  so  great 
as  to  become  a  well-defined  economic  factor.  .  .  .  Earnings 
constitute  the  gauge  of  success  applied  by  a  large  section  of  the 
public  including  many  bankers.  It  is  characteristically  human 
to  uphold  the  successful  enterprise  and  to  obstruct  the  unsuc- 
cessful. A  smaller  percentage  of  money  reserve,  coupled  with 
unqualified  approval,  will  constitute  more  potent  power  of 
support  than  larger  reserves  with  less  or  popular  confidence. 

It  was  furthermore  argued  that  a  piece  of  banking 
machinery  unused  in  normal  periods  could  not  be  made  to 
operate  with  efficiency  on  occasions  of  disturbance.  The 
organization  would  not  be  intact  when  needed.  To  quote 
from  an  address  by  F.  A.  Delano,  a  member  of  the  first 
Federal  Reserve  Board  :^ 

It  might  be  assumed  from  what  has  been  said  that  these 
twelve  Federal  Reserve  banks  exist  solely  to  take  care  of  the 
unusual,  spasmodic  or  seasonable  demands  of  business,  or  else 
those  excessive  demands  which  periodically  come  upon  us  at 
greater  intervals  of  time.  That  alone  might  well  be  called  a 
worthy  object  to  attain,  but  it  would  have  to  be  admitted  that 
a  ponderous  and  costly  machine  had  been  created  to  serve  an 
additional  demand;  and  it  might  be  doubted  whether  a  machine 
thus  kept  in  comparative  idleness  two  thirds  of  the  year  would 
operate  smoothly  and  successfully  when  the  steam  was  turned 
on. 

In  its  Report  for  the  year  1914,  the  Federal  Reserve 
Board  rejected  the  theory  that  continuous  operation 
would  lessen  the  ability  of  the  banks  to  meet  the  panic  or 

'  Cf.  Commercial  and  Financial  Chronicle,  April  8,  1916,  p.  1311. 
»  Cf.  Ibid.,  February  27,  1915,  p.  697. 


DEVELOPMENT,  NOV.,  1914,  TO  DEC,  1916     249 

emergency  needs  of  their  members.^  What  was  required 
was  such  a  control  of  credit,  in  times  of  business  optimism 
as  well  as  of  depression,  that  serious  difficulties  would 
never  arise.  In  periods  of  excessive  activity,  the  banks 
shoul  1  exercise  a  restraining  influence  by  withdrawing 
support  from  the  markets.  In  periods  following  extensive 
liquidation,  they  should  offer  their  funds  freely. 

Normally,  therefore,  a  considerable  proportion  of  its  resources 
should  always  be  kept  invested  by  a  Reserve  Bank  in  order 
that  the  release  or  withdrawal  from  active  employment  of  its 
banking  funds  may  always  exercise  a  beneficial  influence. 

But  no  matter  what  decision  should  be  reached  on 
grounds  of  business  expediency,  the  reserve  administra- 
tion held  the  terms  of  the  statute  were  such  as  clearly  to 
indicate  the  desire  of  the  lawmakers  that  operation  should 
be  continuous.  Aside  from  any  duty  of  earning  dividends 
for  shareholders,  section  14  of  the  act  stated  that  the  rates 
of  discount  "shall  be  fixed  with  a  view  of  accommodating 
commerce  and  industry."  For  occasions  on  which  there 
was  no  demand  for  discounts,  reserve  banks  were  endowed 
with  open-market  powers.  It  seems  to  the  writer  that 
throughout  the  Reserve  Act  there  is  indicated  the  inten- 
tion of  the  lawmakers  that  reserve  banks  should  do  some- 
thing more  than  merely  to  offer  emergency  relief.  The 
reserve  system  was  intended  to  operate  continuously. 

But  the  problem  of  getting  into  the  market  was  one  of 
great  difficulty.  Because  of  the  reduction  in  reserve  re- 
quirements, member  banks  could  expand  their  loans  con- 
siderably without  engaging  in  any  large  amount  of  redis- 
counting.  In  the  early  part  of  1915  the  export  trade  was 
heavy  and  gold  imports  on  an  enormous  scale  began.  The 
member  banks  were  in  so  strong  a  reserve  position  that, 

•See  pp.  17-19 


250  FEDERAL  RESERVE  POLICY 

despite  the  very  moderate  rates  demanded  by  the  reserve 
banks,  there  was  no  large  demand  for  rediscounts.  In  this 
situation,  accordingly,  the  reserve  banks  were  forced  to 
turn  to  their  open-market  powers  in  order  to  find  effective 
use  for  their  funds.  Dealings  in  Government  bonds  and 
municipal  warrants  were  especially  large  in  191 5. 

But  there  were  limits  to  the  extent  to  which  open- 
market  purchases  could  be  made  with  expediency.  The 
reserve  system  was  in  its  infancy,  and  it  was  particularly 
necessary  that  it  avoid  creating  the  appearance  of  being  a 
competitor  of  member  banks.  The  problems\)f  attracting 
a  larger  membership  from  State  institutions  and  of  secur- 
ing the  allegiance  of  all  classes  of  banks  to  the  voluntary 
clearance  plans  had  still  to  be  worked  out.  Despite  the 
fact  that  the  volume  of  operations  at  first  was  not  much 
more  than  sufficient  to  meet  the  expenses  of  operations, 
there  was  a  general  disposition  on  the  part  of  member 
banks  to  view  the  reserve  banks  as  rivals  and  not  as  ser- 
vants. Now  and  then  the  argument  was  advanced  that 
the  capital  stock  subscriptions  of  member  banks  should  be 
returned.  As  typical  of  such  views  the  following  utter- 
ances may  be  quoted  from  an  address  delivered  in  August, 
19 1 5.  by  Frank  C.  Mortimer,  Cashier  of  the  First  National 
Bank  of  Berkeley,  California :  * 

The  present  law  appears  to  place  the  Federal  Reserve  banks 
in  competition  with  member  banks  through  open  market  opera- 
tions. This  has  already  been  availed  of  by  the  purchase  of  war- 
rants and  other  instruments  of  credit.  The  abnormally  heavy 
reserves  now  carried  by  national  banks  might  have  been  profit- 
ably employed  by  them,  at  fair  rates  of  interest,  through  the 
purchase  of  the  very  obligations  now  held  by  the  Federal 
Reserve  banks. 

The  open  market  operations  of  the  Federal  banks  are 
expected,  in  a  measure,  to  regulate  interest  rates  throughout 

•  Cf.  Commercial  and  Financial  Chronicle,  September  18,  1915,  p.  888. 


DEVELOPMENT,  NOV.,  1914,  TO  DEC,  1916     251 

the  country  and  should  be  exercised  in  the  manner  indicated. 
Since  their  organization  there  has  been  no  complaint  regarding 
abnormally  high  interest  charges.  Therefore,  there  appears  to 
be  no  valid  reason  for  any  open  market  operations  at  this  time. 

In  buying  in  the  open  market  the  Reserve  banks  already 
have  been  in  competition  with  member  banks,  and  they  appear 
to  have  demonstrated  that  they  are  operating,  not  altogether 
as  emergency  banks,  to  be  used  during  periods  of  financial 
stress  but  as  open  competiroVs  of  member  banks. 

The  question  naturally  arises:  At  times,  when  there  is  no 
demand  for  the  rediscourtting  privilege,  are  the  Federal  Reserve 
banks  forced  to  compete  with  member  banks  by  going  into  the 
open  market  and  buying  municipal  and  other  warrants,  in  order 
that  they  may  earn  expenses  and  pay  the  expected  dividend  of  6 
per  cent. 

If  this  is  the  situation,  there  exists  a  very  good  reason  for  the 
return  of  the  capitalization  to  the  member  banks  and  the  elimi- 
nation of  the  implied  obligations  on  the  part  of  the  Reserve 
banks  of  earning  a  dividend  of  6  per  cent. 

The  return  of  the  capital  stock  of  Federal  Reserve  banks  to 
member  banks  has  more  than  incidental  bearing  on  the  success 
of  the  whole  system.  With  the  elimination  of  this  feature, 
which  never  has  set  well  upon  the  national  banks,  the  State 
banks,  recognizing  the  value  of  the  rediscount  feature,  in  all 
probability  would  voluntarily  and  quickly  apply  formembership. 

The  desirability  of  returning  the  paid-in  capital  of  the 
reserve  banks  will  depend  upon  the  reader's  conception  of 
the  nature  of  the  reserve  system.  If  he  believes  it  desirable 
that  the  reserve  banks  should  attempt  to  exercise  any 
large  measure  of  continuous  control  over  the  money 
market,  then  he  would  oppose  the  proposal.  Not  until  the 
influence  of  the  reserve  bank  system  was  more  firmly 
established  would  it  appear  feasible  to  lessen  its  resources. 
If,  on  the  other  hand,  the  reserve  system  is  to  operate  in  a 
purely  palliative  manner,  if  it  was  intended  to  confine  its 
services  primarily  to  occasions  of  financial  disturbance, 
greater  objection  would  be  made  to  the  capital  stock 


252  FEDERAL  RESERVE  POLICY 

feature.  For  such  a  system  the  apparent  necessity  of 
earning  dividends  must  prove  a  frequent  source  of  embar- 
rassment. It  might  compel  the  abandonment  or  modifi- 
cation of  poHcies  formulated  solely  in  the  interest  of  finan- 
cial necessities.  But  the  whole  question  throws  into  strik- 
ing relief  the  difficulties  confronting  the  management  at 
the  beginning  of  this  period.  The  reserve  system  must  get 
into  the  market  in  order  to  fulfill  its  purpose.  But  the 
task  of  getting  into  the  market  rendered  inevitable  many 
serious  problems  of  financial  readjustment.  To  employ 
Delano's  figure  of  speech :  ^ 

It  was  like  the  problem  of  reconstructing  a  great  office 
building,  changing  an  antiquated  construction  and  substituting 
therefor  steel  and  marble,  yet  accomplishing  it  all  without 
serious  inconvenience  to  the  tenants. 

As  regards  the  rate  policy  of  the  Board  It  has  been  re- 
marked previously  that  it  was  believed  desirable  to  act 
with  prudence  and  conservatism  at  first.  Accordingly,  in 
the  first  schedule,  rates  were  fixed  at  from  5>2  to  6}4  per 
cent.  But  as  in  the  case  of  qualifications  for  eligibility,' 
it  was  soon  perceived  that  these  requirements  were  too 
high.  Accordingly,  upon  the  applications  of  the  various 
reserve  banks  the  rates  were  lowered  from  time  to  time. 
On  December  30,  19 14,  the  rate  on  30-day  paper  was  4^^ 
per  cent  in  four  districts  and  5  per  cent  in  all  the  others.^ 
Paper  of  longer  maturity  commanded  slightly  higher 
rates.  On  this  date  the  differentials  were  based  entirely 
on  maturities. 

In  1 91 5  further  reductions  were  made.  At  the  close  of 
the  year  the  rate  on  bankers'  acceptances  was  2  to  4  per 

'  See  Bulletin,  October  i,  1915,  p.  298. 

'See  supra,  Chapter  IV,  pp.  82-83. 

J  See  Report  of  the  Federal  Reserve  Board,  1914,  Exhibit  M,  p.  203. 


DEVELOPMENT,  NOV.,  1914,  TO  DEC,  1916     253 

cent,  the  lowest  figure  usually  prevailing;  and  90-day 
trade  acceptances  were  discountable  in  most  districts  at 
3>^  per  cent.  The  30-day  commercial  paper  rate  was  4 
per  cent  in  all  districts,  save  the  San  Francisco  district, 
where  the  rate  was  3^2  per  cent.' 

Save  for  a  slight  tendency  toward  stiffening  at  the  close 
of  the  year,  these  rates  were  not  altered  greatly  during 
1916.^ 

In  order  to  indicate  the  general  discount  situation 
during  these  years,  the  table  on  page  254  (Table  No.  i)  is 
presented.  The  figures  show  that  the  total  volume  of 
discounts  (column  5)  increased  considerably  in  191 6  over 
1915;  1916  also  showed  a  marked  shifting  in  the  maturities 
of  the  paper.  In  191 5  paper  maturing  in  less  than  30  days 
was  exceeded  both  by  the  30-60-day  paper  and  the  60-90- 
day  paper.  In  1916,  however,  paper  of  the  shorter  matur- 
ity exceeded  all  other  classes  combined.  In  fact,  for  the 
month  of  December,  1916,  discounts  of  paper  maturing 
within  30  days  was  considerably  larger  than  the  year's 
total  for  any  of  the  other  classes.  This  may  be  interpreted 
possibly  as  evidence  of  the  increasing  strain  upon  the 
money  market  toward  the  close  of  the  year.  Rediscount- 
ing  was  becoming  more  general  and  member  banks  were 
offering  a  more  representative  lot  of  paper  on  their  redis- 
count applications. 

As  to  the  district  origin  of  the  paper  Table  No.  2  on 
page  254  gives  information.  In  191 5  there  was  little  de- 
mand for  rediscounts  save  in  the  three  Southern  districts 
of  Richmond,  Atlanta,  and  Dallas.  But  in  1916  the  re- 
discounts in  the  Boston,  New  York,  Philadelphia,  and 
Chicago  districts  compared  favorably  with  those  in  the 
three  Southern  districts. 

»  See  Report  of  the  Federal  Reser\'e  Board,  1915,  Exliibil  A,  p.  27. 
«  Cf.  Ibid.,  1916,  Exhibit  A,  pp.  35-39- 


254 


FEDERAL  RESERVE  POLICY 


Table  No.  i 

Volume  of  Discounts  for  Entire  System  by  Types  of  Paper* 

Classification 


Date 


M. MURING 

Within 
30  Days 


30  Days  to 
60  Days 


60  Days  to 
90  Days 


Ac;.  Paper 

Maturing 

After  90  Days 


Total  Com- 
mercial Paper 
Discount  En 


In  Thousa.nds  of  Dollars 


1914 

November 

$  7.306.2 

$  1.929.1 

$      585.6 

$    128.2 

S  9,949.1 

December 

5.074.5 

3,250.9 

2.620  9 

515.6 

11.461.9 

1915 

January 

4.109.3 

3,627.0 

2.365.1 

611.4 

10,712.8 

February 

2.957.5 

5.421.7 

3,265.9 

885.2 

12,530.3 

March 

1.798.6 

5,257.4 

5.162.9 

1.180.8 

13,399.7 

April 

1,239.0 

3,500.9 

4,166.4 

1.643.0 

10,549.3 

May 

1.631.5 

3,800.8 

4.331.1 

2,3H2.3 

12,145.7 

June 

1.810.3 

3,905.3 

5.187.2 

2,503.2 

13,406.0 

July 

1.715.9 

4.512.4 

5.294.3 

1.715.4 

13.238.0 

August 

1.700.3 

4.990.9 

4,520.1 

1.022.4 

12.233.7 

September 

1.829.9 

6,180.0 

5.306.5 

1,088.6 

14.405.0 

October 

2.160.4 

5,327.4 

5.671.0 

1,892.0 

15.050.8 

November 

2.730.8 

6.242.0 

6.791.2 

2,505.7 

18,269.7 

December 

2,825.7 

5.071.6 

5.260.7 

2,254.0 

15.412.0 

Total.  1915 

$  26.509.2 

$57,837.4 

$57,322.4 

$19,684.0 

$161,353.0 

1916 

January 

$     2,118.8 

$  3.359.2 

$  4.121.6 

$  1,515.4 

$  11.115.0 

February 

1,104.3 

2.558.4 

2.995.8 

1,006.1 

7.664.6 

March 

1,202.1 

3,176.7 

3.805.5 

1,203.0 

9.387.3 

April 

4,363.9 

2,373.2 

3.017.1 

1.767.3 

11.521.5 

May 

3,220.0 

2,623.3 

2.961.3 

2,390.9 

11.195.5 

June 

3,271.6 

2,377.6 

3.084.4 

2,926.4 

11.660.0 

July 

10,645.0 

2.747.5 

4,965.8 

1,824.7 

20,183.0 

August 

8.339.6 

3,447.3 

4,521.7 

1.043.2 

17.351.8 

September 

5.342.6 

3.898.4 

4.107.4 

960.4 

14,308.8 

October 

4.392.7 

3.492.6 

3,126.4 

851.5 

11,862.9 

November 

13,497.3 

1,626.1 

1,895.9 

884.8 

17,904.1 

December 

57,555.5 
8115,053.1 

2,742.6 
$34,422.9 

2,973.7 
S41. 576.6 

442  2 

63,716.0 

Total.  1916 

S16,8.?5.9 

$207,870.5 

'  Figures  taken  from  A  nnutU  Reports  of  the  Federal  Reserve  Board. 

Table  No.  2 
Distribution  of  Discounts  by  Districts 


In  Thousands  op  Dollars 

District 

Nov.  16.  1914-Dec.  31.  1915 

J.\N.  1.  1916-D 

EC.  31.  1916 

Per  Cent 

Amount 

IN  1915 

Amount 

Per  Cent 

Boston 

$  2,386.9 

1.3 

$33,921.9 

16.3 

New  York.  . . . 

9,668.7 

30 

22,329.5 

10.7 

Philadelphia  . 

6,839.7 

3-2 

22,328.4 

10.7 

Cleveland 

5.201.3 

2.8 

6,792.4 

3.3 

Richmond  . . . 

47,076.1 

27.8 

34.377.2 

16.5 

Atlanta 

35.336.6 

21.2 

22,323.2 

10.7 

Chicago 

14.648.5 

5.7 

23,178.1 

II.2 

St.  Louis 

8,231.2 

3.9 

8,842.7 

4-3 

Minneapolis. 

5.870.3 

3.2 

6,473-5 

3-1 

Kansas  City . 

11.385.3 

6.8 

6,817.7 

3-3 

Dallas 

27.795-8 

16.6 

18,512.5 

8-9 

San  Francisco 

8,326.6 

4.5 

1.973-4 

I.O 

DEVELOPMENT,  NOV.,   1914,  TO  DEC,  1916    255 

During  these  years  discounting  for  banks  in  the  Nation's 
financial  center,  New  York  City,  was  conspicuous  because 
of  its  almost  total  absence.  The  exceptional  nature  of 
rediscounts  for  the  metropolitan  institutions  is  indicated 
by  the  following  statement  issued  by  the  New  York  Fed- 
f  era!  Reserve  Bank  early  in  December,  1916:  * 

During  the  course  of  the  day  a  number  of  New  York  City 
banks,  including  among  others  .  .  .  made  use  of  the  rediscount 
facilities  of  the  Federal  Reserve  Bank  of  New  York.  While  the 
amounts  of  the  rediscounts  were  not  large,  the  facility  and 
promptness  with  which  the  credits  were  obtained  serves  to  illus- 
trate in  a  practical  way,  for  the  first  time  in  the  history  of  the 
bank,  the  readiness  of  the  Federal  Reserve  system  to  meet  the 
calls  made  upon  it.  The  officers  of  the  Reserve  Bank  expressed 
'  themselves  as  much  gratified  with  the  attitude  of  the  member 
banks  in  making  use  of  their  facilities,  it  being  apparent  that 
the  rediscounting  had  been  undertaken  not  so  much  because 
there  was  any  necessity  for  it,  but  rather  to  inaugurate  the  prac- 
tice which,  while  already  a  commonplace  at  other  Federal 
Reserve  banks,  had  not  heretofore  become  an  established  pro- 
cedure in  New  York. 

The  number  of  member  banks  accommodated  through 
the  discount  of  commercial  paper  was  somewhat  similar 
in  the  two  years.  In  1916,  23.4  per  cent  of  all  member 
banks  received  discount  credits  from  reserve  banks.  The 
figures  for  19 14,  191 5,  and  191 6  were  as  in  Table  No.  3 
on  page  256. 

According  to  the  figures  of  Table  No.  4  on  page  256, 
the  amount  of  paper  most  commonly  discounted  during 
1916  was  ^1000  to  ^2500.  But  approximately  an  ccjuiva- 
lent  amount  of  pieces  in  size  from  ^250  to  ^500  and  ^500 
to  ^1000  were  discounted.  More  pieces  of  paper  under  j?  100 
were  discounted  than  from  ^5000  to  ^10,000,  These  facts 

'  Cf.  Commercial  and  Financial  Chronicle,  December  9,  19 16,  p.  21 18. 


256 


FEDERAL  RESERVE  POLICY 


Table  No.  3 

Number  of  Member  Banks  Accommodated  Through  Discoxjnt 

OF  Commercial  Paper 


District 

Nov.  16.  1914-Dec.  31,  1915 

1915 

1916 

Boston 

29 

54 

70 

88 

226 

248 

221 

197 
274 
366 
169 

19 
49 
65 

81 

226 

247 
143 

129 

176 

258 

360 

167 

1,920 

56 

New  York 

62 

Philadelphia 

143 

Cleveland 

50 

Richmond 

202 

Atlanta   

209 

Chicago 

212 

St.  Louis 

114 

Minneapolis 

174 

Kansas  City 

189 

Dallas 

301 

San  Francisco 

76 

Total 

2,073 

1,788 

Table  No.  4 
Commercial  Paper  Discounted  by  Size  for  the  Year  1916' 


Size 


To  $100 

$100-250. . . . 

250-500.... 

500-1000. . . 

1000-2500. . 

2500-5000. . 

5000-10,000 

Over  $10,000 

Total.  .. 


Amount  in  Thousands 

OF  Dollars 

4.407 

$      322.6 

12,088 

2,1374 

14.551 

5.670.8 

14.907 

II.39L5 

15.460 

26,120.4 

9,6o8 

38,756.2 

3.391 

26,750.9 

1,871 

96.720.7 

76,283 

207,870.5 

»  See  Report  of  the  Federal  Reserve  Board.  1916,  p.  91. 

tend  to  combat  the  assertion  that  the  principal  advantages 
of  the  reserve  system  would  enure  to  the  large  borrower. 

Table  No.  5  on  page  257  gives  certain  information 
regarding  the  amount  of  the  open-market  purchases  dur- 
ing 1915  and  1916. 


DEVELOPMENT,  NOV.,   1914,  TO  DEC,   1916    257 
Table  Xo.  5 

Total  Investment  Operations  (PaRciiASED  Paper  and  Discounted 

Paper) 

In  Thousands  of  Dollars 


Date 

co.mmercial 

Paper 
Discounted 

Purchased  i 

Acceptances 

Bankers'  and 

Trade 

United  States 

Bonds 

Purchased 

Municipal 
Warrants 
Purchased 

1914 
November  .  . 
December . . . 

1915 

January  

February  . .  . 

March 

April 

May 

June 

July 

August 

September .  . 
Octolier  .... 
November  . . 
December.  . . 

$    9,949-1 
11,461.9 

10.712.8 
12,530.3 
13,399-7 
10,549.3 
12,1457 
13,406.0 
13,238.0 

12,233-7 
14,405.0 
15,050.8 
18,269.7 
15,412.0 

$    2,666 

8.336 
4,'>i8 
2,865 

4,701 
5,9S6 
4,656 
4.548 
6,340 
7,919 
12,790 

$      205 

2,650 

2,566 

1.340 

75 

285 

559 

477 

735 

488 

1,200 

2,988 

2,347 

$      677 

10,087 
2.583 
3,739 
3,196 
4,946 
4,512 
7,346 

11.750 
4.II5 
1.370 
9,001 
3,210 

Total  19 1 5 

1916 
January  .... 
February  . .  . 

March 

April 

May 

June 

July 

August 

September  . . 
October  .... 
November  . . 
December. . . 

$161,353-0 

$  11,115 
7.664 
9,387 
11,521 
11,195 
11,660 
20,183 
17.351 
14.308 
11,862 
17,904 
63,716 

$64,845 

$    9,602 
12,416 
22,918 
18,499 
21,911 
42,325 
36,575 
28,446 
37,086 
40,894 
48,547 
66,871 

$15,918 

$  6.627 

9,496 

8.249 

10,479 

6,113 

1,322 

341 

501 

2,193 

257 

5,628 

5,539 

$65,859 

$  9,806 
10,450 
10,425 
10,361 

8,979 
5.477 
7.254 
1,602 

5.t>90 
10,267 

7.565 
3.404 

Total  1916  . 

$207,870 

5386,095 

$56,750 

I90.6.S6 

•  First  purchase  of  acceptances,  February  19,  1915. 


By  means  of  these  operations  the  reserve  banks  were 
able  to  make  a  fair  showing  regarding  earnings  in  19 15 


258  FEDERAL  RESERVE  POLICY 

and  19 1 6.  In  these  two  years  all  earned  expenses  and  were 
able  to  contribute  a  small  amount  to  dividends.  From  the 
Report  of  the  Federal  Reserve  Board  for  the  year  1916  we 
read :  ^ 

The  figures  for  the  whole  system  to  December  31,  191 6, 
show  an  average  net  earning  since  organization  of  3  per  cent  on 
the  actual  paid-up  capital,  while  for  the  year  1916  they  show 
an  average  net  earning  of  5  per  cent. 

In  comparing  reserve  banks*  operations  with  those  of 
private  Institutions,  it  must  be  remembered,  however, 
that  a  portion  of  their  capital  is  obtained  without  the 
issuance  of  stock.  The  law  required  member  banks  to 
deposit  a  portion  of  their  reserves  with  the  reserve  banks. 

Because  of  the  rather  limited  scale  of  its  operations,  the 
reserve  system  approached  the  close  of  this  period  with 
exceedingly  high  reserves.  December  30,  19 16,  the  ratio 
of  the  gold  reserves  of  the  reserve  banks  to  the  net  deposit 
and  Federal  Reserve  note  liabilities  was  79.4  per  cent. 
On  this  date  the  cash  reserve  ratio  was  81.4  per  cent. 

Despite  the  limited  demands  upon  its  resources,  it 
appears  undeniable  to  the  writer  that  in  this  period  the 
reserve  management  should  be  credited  with  a  remarkable 
achievement.  The  legitimate  needs  of  business  were  met 
without  the  sacrifice  of  principle  on  the  one  hand  or  the 
establishment  of  unduly  bureaucratic  methods  upon  the 
other.  The  requirements  for  eligibility  of  paper  presented 
for  rediscount  were  fair.  The  practice  of  discounting  had 
become  sufficiently  prevalent  to  point  the  way  to  member 
banks  for  the  solution  of  their  future  emergency  require- 
ments. Analysis  of  the  number  of  banks  served,  of  the 
size  of  the  paper  discounted,  of  the  districts  of  origin,  gave 
results  which  could  not  be  employed  to  justify  charges  of 
favoritism.   The  reserve  management  had  convinced  the 

»  Page  13. 


DEVELOPMENT,  NOV.,  1914,  TO  DEC,  1916    259 

member  banks  that  its  services  were  at  the  disposal  of  all 
banks  and  all  districts. 

While  progress  in  popularizing  the  trade  acceptance 
was  slow,  it  had  proceeded  upon  a  sound  basis.  The  firms 
won  over  to  its  use  were  in  large  measure  those  of  high 
credit  rating.  Progress  in  the  popularization  of  the  bank- 
ers' acceptance  was  favorable. 

In  check  collections  the  reserve  system  had  proceeded 
slowly  but  cautiously.  But  by  the  middle  of  19 16  the 
foundations  had  been  laid  for  a  country-wide  par  clearance 
scheme  which  was  finally  to  include  the  greater  part  of  the 
country's  banks,  non-member  as  well  as  member.  These 
steps  had  to  be  taken  in  the  face  of  much  legislative  and 
political  objection  engendered  by  the  large  number  of 
exchange-charging  banks. 

By  amendments  to  the  act  and  various  administrative 
measures,  much  progress  had  been  made  in  the  movement 
to  conserve  the  Nation's  gold  supply.  On  December  29, 
1916,  its  total  gold  reserve  was  ^453,000,000.  On  the  same 
date  a  total  of  ^282,000,000  was  deposited  with  the  re- 
serve agents  as  cover  for  the  Federal  Reserve  note  issues. 
The  reserve  banks  were  accumulating  gradually  a  larger 
and  larger  portion  of  the  country's  gold.  This  concentra- 
tion of  gold  increased  the  reserve  system's  power  for  evil 
as  well  as  for  good.  But  it  would  not  have  been  courageous 
to  have  declined  to  accept  this  opportunity. 

No  occasions  for  inter-district  rediscounting  occurred 
in  this  period.  But  knowledge  of  the  possiliilities  of  secur- 
ing extra-district  aid  enabled  industry  to  count  upon 
the  support  of  its  banks  with  greater  certainty. 

In  the  Gold  Settlement  Fund  at  Washington  the  begin- 
nings had  been  laid  for  a  machinery  which  finally  was  to 
enable  domestic  transfers  of  currency  to  be  made  with  a 
minimum  of  cost  and  physical  effort. 


260  FEDERAL  RESERVE  POLICY 

The  principal  disappointment  had  to  do  with  the  refusal 
of  the  great  majority  of  State  banks  to  enter  the  system. 
But  it  seems  clear  that  only  by  undesirable  concessions 
could  the  system  have  been  made  such  as  to  attract  the 
voluntary  entrance  of  many. 

Lastly,  the  internal  organization  had  been  developed 
to  meet  the  requirements  of  the  future.  The  preliminary 
work  had  been  accomplished.  This  period  was  one  of 
achievement.  But  primarily  the  achievements  were  those 
of  preparation. 


CHAPTER  XIII 

FEDERAL  RESERVE  DEVELOPMENT,  JANUARY,  1917 
TO  APRIL,  1917 

In  the  early  period  of  reserve  operation  the  demand  for 
rediscounts  was  hght  and  the  reserve  banks  were  able  to 
exercise  little  control  over  the  money  market.  Toward  the 
close  of  1916,  however,  the  general  boom  in  industry  had 
begun  to  throw  some  strain  upon  the  credit  mechanism. 
As  a  consequence  several  reserve  banks  in  December,  1916, 
increased  their  rates  slightly  and  for  the  first  period  of 
their  existence  the  member  banks  became  somewhat  sensi- 
tive to  their  rediscount  policy.  As  stated  by  Governor 
Harding  in  the  January,  1919,  Bulletin: 

the  only  period  when  the  Federal  Reserve  Board  was  able  to 
exercise  any  effective  control  over  the  banking  situation  was 
during  the  last  two  or  three  months  of  1916  and  the  first  quarter 
of  1917.* 

It  might  be  expected,  accordingly,  that  1916  would 
mark  the  close  of  the  period  of  experiment  and  prepara- 
tion, and  that  permanent  principles  governing  rediscount 
and  open-market  operations  would  soon  crystallize.  Prior 
to  1917  there  was  no  danger  of  credit  and  currency  infla- 
tion. The  inflow  of  gold  from  Europe  and  the  reduction 
of  reserve  requirements  by  the  terms  of  the  act  left  mem- 
ber banks  in  an  exceedingly  strong  reserve  position.  Under 
this  situation  member  banks  could  provide  credits  without 
great  deference  to  the  pulley  of  the  rescr\'e  administra- 
tion. There  was  then  little  objection  to  be  made  to  the  low 

•  Page  2. 


262  FEDERAL  RESERVE  POLICY 

rates.  Rather  they  appeared  to  be  an  outright  advantage. 
In  the  first  place,  these  low  rates  tended  to  encourage 
member  banks  to  make  rediscount  applications  and  thus 
emphasized  the  helpful  possibilities  of  the  system.  Sec- 
ondly, they  served  to  indicate  the  fundamental  soundness 
of  America's  financial  condition. 

No  system  of  central  banking,  however,  can  continue 
forever  to  serve  as  an  agency  for  credit  expansion,  and  it 
might  be  expected,  accordingly,  that  in  19 17  a  beginning 
would  be  made  in  establishing  a  permanent  basis  for 
advances  to  member  banks.  The  principle  accepted  might 
be  to  keep  the  reserve  banks'  rates  above  those  of  the 
general  market  or  to  base  the  volume  of  rediscounts  upon 
the  productive  requirements  of  the  community  where  the 
applications  arose.  But  no  matter  what  the  basis  of  pro- 
cedure, it  was  clear  to  all  thinkers  that  in  the  first  two 
years  of  operation  no  real  progress  had  been  made  in  this 
direction.  Financial  conditions  in  these  years  were  such 
as  to  make  unnecessary  the  solution  of  this  problem. 

As  political  events  shaped  themselves,  however,  neither 
1917  nor  any  subsequent  year  was  to  be  such  as  to  permit 
idealistic  consideration  of  the  proper  basis  for  rediscount 
operations.  Very  early  in  19 17  it  became  clear  that  only 
by  receding  from  our  oft-stated  position  regarding  the 
rights  of  neutrals  armed  clash  with  Germany  could  be 
avoided.  Prospects  of  entering  the  conflict  overshadowed 
all  other  considerations,  and  the  task  of  the  reserve  admin- 
istration was  to  place  the  reserve  banks  in  shape  to  meet 
the  financial  strain  of  war.  It  was  understood  that  the 
Treasury's  plan  would  involve  huge  borrowing  operations 
and  that  these  could  be  rendered  successful  only  by  the 
active  cooperation  of  the  banks.  Credits  would  be  re- 
quired, not  merely  to  finance  our  own  expenditures,  but 
also  those  of  our  allies  whose  purchase  of  war  supplies  in 


DEVELOPMENT,  JAN.,  1917,  TO  APRIL,   1917    263 

this  country  would  increase  as  a  result  of  our  declaration 
of  war.  A  credit  system,  moreover,  not  efficiently  ordered 
before  war,  could  scarcely  be  expected  to  be  prepared 
during  hostilities  for  the  requirements  of  post-war  recon- 
struction. The  problem  then  would  exist  of  transferring 
labor  and  capital  from  the  production  of  war  supplies  to 
the  industries  of  peace. 

It  was  during  this  period,  accordingly,  that  much  of  the 
work  of  concentrating  the  control  of  the  country's  gold 
was  accomplished.  In  January  the  Board  proposed  the 
amendments  which  became  law  June  21,  19 17,  and  which 
required  member  banks  to  maintain  their  entire  legal 
reserves  with  reserve  banks.  The  Board  also  suggested 
that  it  be  given  power  to  raise  the  reserve  requirements  of 
member  banks  in  emergencies.  Congress  refused,  however, 
to  accept  this  amendment.  At  the  same  time  proposals 
were  made  to  render  membership  more  attractive  to  State 
banks  and  trust  companies  and  preparations  were  made 
for  ensuring  an  adequate  supply  of  Federal  Reserve  notes. 

During  the  months  of  January  and  February  it  placed  addi- 
tional orders  with  the  Bureau  of  Engraving  and  Printing, 
through  the  Comptroller  of  the  Currency,  for  more  than 
$900,000,000  of  notes,  and  arranged  also  that  the  stock  of  notes 
on  hand  should  no  longer  be  reduced  through  withdrawals  for 
current  needs,  but  that  as  drawn  upon  by  the  Federal  Re- 
serve Banks  new  orders  in  equal  amount  should  be  placed 
automatically.* 

In  view  of  the  anticipated  future  strain  it  might  have 
been  expected  that  discount  rates  would  have  been  in- 
creased during  this  period.  The  state  of  the  money 
market,  however,  was  such  as  to  necessitate  compara- 
tively few  alterations.  For  instance,  the  rates  on  commer- 
cial paper  maturing  within  61  to  90  days  were  increased 

'  Report  of  the  Federal  Reserve  Board,  19 17,  p.  2. 


264  FEDERAL  RESERVE  POLICY 

in  this  period  in  only  two  districts.  In  January,  the 
Atlanta  and  Dallas  banks  increased  their  charges  one  half 
of  one  per  cent. 

With  these  rates  the  discounts  for  member  banks  of 
the  first  quarter  of  the  year  totaled  ^67,523,7  thousand. 
This  compares  with  totals  of  ^28,166.9  thousand  and 
^36,642.8  thousand  in  the  corresponding  periods  of  1916 
and  19 1 5.  The  dependence  of  member  banks  upon  re- 
discounting  was  increasing  somewhat. 

It  might  be  surmised  that  this  increased  rediscounting 
must  have  been  at  the  expense  of  the  reserve  banks'  legal 
reserves.  It  is  true  that  the  reserve  accounts  of  members 
on  the  books  of  reserve  banks  increased  somewhat.  On 
January  26,  members'  reserve  accounts  were  ^687,841,000. 
On  February  23,  they  were  ^692,475,000  and  on  March  30, 
^720,411,000.  The  circulation  of  Federal  Reserve  notes, 
on  January  26,  was  ^259,768,000;  on  February  23, 
^303»i7i.ooo;  and,  on  March  30,  ^357,610,000.  But  as  a 
result  of  the  continuous  impounding  of  gold  the  total  cash 
reserves  advanced  steadily  from  ^758, 242,000  on  January 
5  to  ^962,662,000  on  April  6.^  Consequently,  the  ratio  of 
cash  reser\^es  to  aggregate  net  deposits  and  Federal  Re- 
serve note  liabilities  remained  continuously  above  82 
per  cent.  On  April  6,  the  date  of  the  declaration  of  war, 
it  was  84  per  cent. 

The  enlarging  gold  holdings  of  the  reserve  banks  made 
possible  also  an  increase  in  the  open-market  investment 
operations  without  lowering  the  reserve  ratio.  This  is 
indicated  by  the  table  on  page  265.^ 

On  January  5,  1917,^  the  gold  of  the  reserve  banks 
in    excess    of    required    reserves  —  free    gold,    in    other 

'  Report  of  the  Federal  Reserve  Board,  19 17,  p.  64. 
'  Ibid.,  p.  131. 
*  Ibid.,  p.  70. 


DEVELOPMENT,  JAN.,  1917,  TO  APRIL,  1917   265 

Amount  Purchased  in 

January 

February 

March 

1917 

1916 

1915 

S49. 105,356 
37.i5o,9''<o 
23,450,300 

599,502,895 
40,028,950 
20,345,800 

$66,495,153 
50,981,150 
26,834,9<xj 

words  —  amounted  to  ^421,155,000.  On  April  6  it  had 
increased  to  ^545»959.ooo-  On  the  basis  of  this  free  gold 
an  enormous  expansion  of  credit  advances  to  memlxT 
banks  or  of  Federal  Reserve  note  issues  was  possible. 
This  free  gold  would  provide  a  40  per  cent  reserve  for  a 
deposit  or  note  expansion  of  ^1,164,697,500.  This  would 
exceed  the  sum  of  the  outstanding  Federal  Reserve  note 
circulation  and  book  credit  advances  to  member  banks 
(^1,134,729,000)  by  329,978,500.  And  the  process  of 
attracting  gold  into  the  reserve  reser\'oir  had  yet  to  attain 
full  proportion.  Few  State  banks  had  joined  the  system, 
and  the  amendment  of  June  21,  19 17,  requiring  member 
banks'  legal  reserves  to  be  kept  in  their  entirety  in  reserve 
banks,  had  not  yet  been  enacted. 

In  view  of  the  fact  that  this  period  closes  before  the 
amendment  of  June  21,  1917,  and  in  view  of  the  further 
fact  that  the  reserv^e  banks'  reserves  were  to  be  enlarged 
by  successive  accretions  of  gold,  it  would  be  unprofitable 
to  calculate  the  amount  of  credit  and  note-issue  expansion 
which  the  reserve  banks'  reserves  would  support  on  the 
date  of  the  outbreak  of  the  war.  But  a  few  facts  relating 
to  the  conditions  of  memlx^r  banks  will  serve  to  enable  us 
better  to  understand  the  credit  situation  at  this  time. 

March  5,  19 17,  the  required  reserve  for  the  net  deposits 
of  member  banks  was  not  quite  15.5  hundred  millions  of 
dollars.  On  this  date  the  actual  reserve  (vault  reserve, 
plus  amount  due  from  Federal  Reserve  banks  plus  amount 
due    from    reserve    agents)    was    almost    26.5    hundred 


266  FEDERAL  RESERVE  POLICY 

millions/  Irrespective  of  any  further  aid  to  be  secured 
through  rediscounts,  the  member  banks,  as  a  whole,  were 
in  an  exceedingly  strong  reserve  position. 

These  facts  should  not  be  interpreted,  however,  as  pro- 
viding solely  a  basis  for  congratulation.  It  is  true  that 
the  public  and  the  banks  were  destined  to  support  a  war 
finance  programme  of  unparalleled  magnitude.  It  is  also 
undebatable  that  without  the  Federal  Reserve  all  this 
would  have  been  impossible.  But  it  is  still  true  that  the 
huge  surplus  reserves  gave  a  false  sense  of  security.  They 
seemed  to  justify  expenditures  by  the  Government  of  any 
amount  for  any  purpose.  Much  delay  and  many  mishaps 
were  to  be  encountered  before  it  came  to  be  realized  that 
the  problem  of  war  finance  was  not  primarily  one  of  sup- 
plying dollars,  but  rather  one  of  securing  for  war  purposes 
labor  and  materials.  Some  time  was  to  elapse  before  it 
could  be  understood  generally  that  labor  and  materials 
were  limited  in  supply  even  if  dollars  were  not. 
'  Cf.  Bulletin,  June  i,  19 17,  p.  484. 


CHAPTER  XIV 

FEDERAL  RESERVE  DEVELOPMENT,  MAY,  1917, 
TO  NOVEMBER  11,  1918 

The  general  policy  of  the  Federal  Reserve  administration 
during  the  period  of  our  participation  in  the  World  War 
may  be  epitomized  briefly  as  one  of  complete  and  cordial 
cooperation  with  the  Treasury.  Once  the  Treasury  had 
announced  its  plans,  the  banking  machinery  was  adapted, 
so  far  as  possible,  to  the  work  of  furnishing  the  necessary 
financial  support.  To  quote  from  the  Bulletin  for  January 
I,  1918:^ 

Under  the  leadership  of  the  Secretary  of  the  Treasury  '  the  banks 
have  done  their  duty  admirably  in  placing  both  the  short-  and 
long-term  securities  of  the  Government. 

The  financial  story  of  the  war  can  thus  be  read  to  a  very 
large  extent  in  the  policies  of  the  Federal  Reserve  Board. 

The  first  respect  in  which  the  reserve  banks  were  called 
upon  to  lend  their  facilities  to  the  Treasury  was  in  con- 
nection with  the  sale  of  short-term  Treasury  certificates. 
Only  to  a  limited  extent  were  funds  for  war  purposes 
obtained  in  advance  of  disbursements  by  means  of  taxa- 
tion or  bond  sales.  In  large  measure  funds  would  Ix; 
acquired  first  through  the  sales  of  short-term  certificates. 
Upon  their  due  dates  the  accumulated  certificates  would 
be  retired  through  the  proceeds  of  taxation  and  bond  sales. 

The  Treasury  announced  at  an  early  date  its  intention 
to  follow  this  policy.  On  April  20,  19 17,  Secretary  McAdoo 

'  Page  I . 

*  Italics  are  the  writer's. 


268  FEDERAL  RESERVE  POLICY 

stated  that  as  soon  as  the  War  Loan  Bill  became  law  sev- 
eral hundred  million  three  per  cent  certificates,  payable 
June  30,  would  be  issued.*  In  order  to  avoid  temporary 
shortage  of  banking  funds  in  the  communities  where  the 
certificates  were  purchased,  the  Treasury  stated  that 
disbursements  would  be  made  in  such  a  way  "that  as  far 
as  possible  money  paid  in  will  be  promptly  returned  to  the 
market."  ^  But  in  case  these  measures  should  prove  in- 
sufficient, it  was  announced  by  Governor  Harding  that  * 
"the  Federal  Reserve  Banks  may  be  counted  upon  by 
offering  liberal  terms  of  rediscounting  to  do  their  utmost 
in  counteracting  any  effect  of  temporary  dislocation  of 
banking  funds."  Within  a  month  there  were  three  issues 
of  these  certificates  totaling  ^650,000,000. 

But  what  specific  measures  should  be  provided  to 
render  effective  this  offer  of  support  to  member  banks? 
It  was  evident  that  no  alterations  need  be  made  in  the  laws 
or  regulations  governing  eligible  paper.  The  original  act 
permitted  the  reserve  banks  to  rediscount  customers' 
paper  drawn  for  the  purpose  of  carrying  bonds  of  the 
Government  of  the  United  States.  Since  the  amendment 
of  September  7,  19 16,  provision  had  existed  for  the  direct 
discount  of  member  banks'  promissory  notes  secured  by 
"pledge  of  bonds  or  notes  of  the  United  States"  as  well  as 
by  eligible  paper.  Federal  Reserve  support  was  in  large 
measure,  therefore,  a  question  of  the  rates  of  discount. 

In  the  Bulletin  of  June  i,  1917,  we  read : '' 

The  Board,  therefore,  recently  took  under  consideration  the 
question  of  establishing  a  rate  of  discount  for  the  short-term 
notes  of  member  banks  secured  by  Liberty  bonds  or  by  short- 
term  certificates  as  collateral,  as  well  as  the  question  of  a  favor- 

I  Bulletin,  May  i,  1917,  pp.  341-42 

» Ibid. 

» Ibid.,  p.  342. 

*  Page  425. 


DEVELOPMENT,  MAY,  1917,  TO  NOV.   11.  1918     269 

able  rate  of  rediscount  for  customers'  notes  collateraled  by  such 
bonds  or  certificates  and  offered  by  the  member  banks  to  the 
reserve  banks  with  their  own  endorsement. 

As  a  result  of  this  consideration  the  Board  announced  in 
May  its  willingness  to  approve  a  rate  of  3  per  cent  on 
member  banks'  notes  collateraled  by  war  paper.  On  May 
22,  it  issued  a  circular  stating  that  it  would  ratify  a  rale 
^^^  SH  per  cent  on  the  rediscount  of  customers'  notes 
maturing  within  ninety  days  secured  by  Government 
bonds  or  Treasury  certificates.  Since  the  first  war  bonds 
bore  interest  at  3>^  per  cent,  the  bond  sul)scriber  was 
icxirly  well  protected  against  the  dangers  of  subscriptions 
exceeding  his  ability  to  pay. 

Inasmuch  as  the  rate  of  interest  increased  on  later  issues 
of  war  bonds,  it  would  be  expected  that  the  rcser\^e  banks' 
rates  would  increase  also.  Accordingly  on  the  date  of  the 
armistice  the  rate  was  4X  per  cent  on  16-90-day  paper 
secured  by  war  issues.  In  addition  to  these  measures 
some  use  was  made  of  a  3-4^^  per  cent  rate  on  one-day 
discounts  arising  in  connection  with  the  Government's 
loan  operations. 

It  did  not  seem  feasible  to  the  reserve  management  to 
establish  high  rates  on  other  types  of  paper  even  in  this 
period  of  capital-strain.  All  rates  of  interest  are  more  or 
less  closely  related.  High  money  charges  exacted  from  the 
public  on  business  loans  would  increase  the  difllculty  of 
selling  war  bonds  at  low  rates.  Accordingly  the  90-day 
rate  on  commercial  paper,  which  on  April  30,  1917,  was 
4  per  cent  in  five  districts,  and  43^  per  cent  in  seven,  was 
advanced  only  slightly  during  the  period  of  hostilities. 
On  the  date  of  the  armistice  it  was  4^  per  cent  in  seven 
districts  and  5  per  cent  in  the  others. 

But  the  reserve  banks  did  not  confine  their  efTorts  to 
keeping  their  own  rates  low.   In  many  ways  they  endeav- 


270  FEDERAL  RESERVE  POLICY 

ored  to  bring  pressure  on  member  banks  to  offer  loans  to 
the  public  cheaply,  as  well  as  to  maintain  low  rates  on 
deposits.  For  instance,  in  the  schedule  of  rates  for  Octo- 
ber 31,  1918,  the  member  banks'  ability  to  secure  a  4 
rather  than  a  4>^  per  cent  rate  would  depend,  in  two 
districts,  upon  whether  the  customer's  paper  had  been 
discounted  at  a  rate  not  exceeding  that  borne  by  the 
bonds.  On  several  occasions  we  find  the  reserve  admin- 
istration cautioning  banks  against  raising  rates  allowed  on 
deposits.  To  quote  from  a  letter  by  Governor  Harding  of 
February  26,  1918:^ 

Banks  should  remember  that  when  deposits  are  reduced 
reserves  are  released.  Reckless  competition  for  deposits  sup- 
ported by  high  interest  rates  will  tend  to  force  the  Government 
to  pay  higher  rates,  thereby  imposing  additional  burdens  on  the 
people;  and  any  forced  and  artificial  expansion  of  banking 
credits  will  promote  rather  than  check  inflationary  tendencies, 
which  should  be  guarded  against  at  the  present  time.  There 
does  not  seem  to  be  any  demand  on  the  part  of  depositors  for 
increased  rates  of  interest  on  their  balances,  and  the  Board 
wishes  it  understood  that  it  does  not  favor  any  movement  to 
increase  these  rates  and  that  it  will  do  all  in  its  power  to  dis- 
courage it. 

Because  of  the  enormous  demand  upon  the  reserv^e 
banks'  rediscounting  facilities  during  the  war,  mere  sug- 
gestions from  the  Board  were  undoubtedly  more  than 
ordinarily  efficacious.  But  enough  has  been  stated  to  indi- 
cate the  complete  cooperation  of  the  reserve  banks  with 
the  Treasury.  The  writer  has  found  no  important  instance 
in  which  there  was  displayed  an  unwillingness  to  refuse 
support  for  the  Treasury's  low  interest  policy  in  the  sale 
of  war  bonds. 

In  the  preceding  chapter^  some  information  has  been 

'  See  Bulletin,  April  i,  1918,  p,  252. 

'  See  supra,  pp.  264,  265. 


DEVELOPMENT,  MAY,  19 17,  TO  NOV.  11,  19 18    271 

given  regarding  the  ability  of  the  reserve  and  member 
banks  to  meet  the  demands  upon  them.  There  it  was 
shown  that,  at  the  outbreak  of  hostilities,  the  member 
banks'  surphis  reserves  were  huge  and  that  the  free  gokl 
of  the  reserve  banks  would  permit  more  than  a  doubling 
of  the  issues  of  Federal  Reserve  notes  and  of  credit 
advances  to  member  banks.  But  the  expansive  possi- 
bilities of  the  system  should  be  calculated  on  a  date  sub- 
sequent to  the  amendment  of  June  21,  1917,  which  lowered 
reserve  requirements  and  provided  for  their  transfer  in 
entirety  to  reserve  banks.  Since  the  Comptroller's  figures 
bearing  upon  the  condition  of  national  banks  may  be  had 
for  November  20,  19 17,  the  writer  has  selected  November 
23  as  the  date  for  his  calculations  as  to  the  amount  of 
bank  credits  the  surplus  reserves  of  reserve  banks  might 
enable  member  banks  to  grant  the  public.  All  figures  are 
given  in  thousands  —  i.  e.,  000  omitted.  * 

1.  Gold  reserve  for  federal  reserve  notes. 

On   November  23,   1917,  the  gold  reserve  for  note  issues 
totaled  $635,497  ($623,948  deposited  with  the  reserve  agents 
plus  $11,549  in  the  gold  redemption  fund). 
'    On  this  date  the  notes  in  actual  circulation  totaled  $1,051,892. 

The  actual  gold  reserve  was  —  -  '^      or  62.5  per  cent.    The 

1,015,892 

minimum  40  per  cent  required  would  be  $406,356. 

The  excess  reserve  for  notes  was  $635,497  less  $406,356  or 

$229,140. 

2.  Possibilities  of  further  note  expansion. 

Supposing  the  excess  reserve  for  notes  to  be  used  to  support 
the  maximum  value  of  notes,  a  further  note  issue  is  possible  of 
2>^  times  $229,140  or  $572,850. 

3.  Reserve  for  member  bank  deposits.' 

'  This  calculation  is  quoted  from  H.  L.  Reed,  "Credit  Expansion  under  the 
Federal  Reserve,"  American  Economic  ReviaL',  June,  1918,  pp.  270-8^.  See 
pp.  279,  280. 


272  FEDERAL  RESERVE  POLICY 

On  November  23,  19 17,  the  net  deposits  of  all  the  reserve 
banks  totaled  $1,546,122;  computed  as  follows: 

Government  de[X)sits $    196,411 

Due  to  members  (reserve  account) 1,426,648 

Due  to  non-members  (clearing  account).  . .  .        22,291 
Collection  items 215,169 

Total  gross  deposits $1,860,519 

Due  from  other  reserve  banks,  net $  11,872 

Uncollected  items 302,525 

Total  deductions 314.397 

Net  deposits $1,546,122 

The  gold  reserve  for  net  deposits  totaled  $969,207,  as  follows: 

Gold  coin  and  certificates  in  vault $530,045 

Gold  settlement  fund 385,662 

Gold  with  foreign  agencies 52,500 

Total $969,207 

The  gold  reserve  for  deposits  was  — ^—^ — -  or  62.6  per  cent. 

1,546,122 

The  total  lawful  money  reserve  for  depos- 
its (gold  reserve  plus  legal  tender  notes, 
silver,  etc.)  was  $969,207  plus  $54,058 
or $1,023,265 

The  lawful  money  reserve  required  (35 

per  cent  minimum)  would  be 541,142 

The  surplus  reserve  for  deposits  was $     482,123 

4.  Possibilities  of  further  expansion  of  deposit  credits  of  re- 
serve banks. 

•  Supposing  the'surplus  reserve  for  deposits  to  be  used  to  sup- 
port the  maximum  volume  of  member  bank  deposits,. an  increase 

in  these  is  possible  of times  $482,123  or  $1,377,494.     This 

35 
represents  a  potential  increase  of  more  than  95  per  cent.  (Mem- 
ber bank  deposits  with  reserve  banks  on  November  23  equaled 
$1,426,000.) 

5.  Possibilities  of  further  expansion   of   deposit    liabilities   of 
member  banks. 


DEVELOPMENT,  MAY,  191 7,  TO  NOV.  11,  19 18    273 

Supposing  that  the  required  reserve  for  member  banks  aver- 
ages 10  per  cent,  and  that  the  $1,377,494  should  be  used  to  the 
maximum  amount  to  support  their  deposit  grants  to  the  pubHc, 
an  increase  in  these  is  possible  of  to  10  times  $1,377,494  or 
$13,774,940-  This  represents  a  potential  expansion  of  more 
than  90  per  cent.  (Total  deposit  liabilities  of  national  banks 
on  November  20,  were  $14,798,000.)  An  increase  of  note  issues 
by  $572,850  would  probably  furnish  all  the  till  money  necessary 
to  support  the  $13,774,940  of  bank  deposits. 

But  even  these  figures  do  not  show  the  full  possibilities 
of  credit  expansion  on  this  date.  No  account  is  taken  of 
the  huge  surplus  cash  then  reposing  in  the  vaults  of  mem- 
ber banks.  Much  new  gold,  moreover,  was  to  continue 
to  accumulate  in  the  vaults  of  reserve  banks  and  many 
large  and  powerful  State  institutions  were  yet  to  enter 
the  system. 

To  what  extent  we  may  next  inquire  was  this  expansive 
power  of  the  Federal  Reserve  utilized  during  the  period 
of  hostilities?  The  following  figures  show  the  amount  of 
the  total  investment  operations  of  reserve  banks/ 

1917 

May $    174,128,766 

June 887,502,360 

July 547,434,069 

August 297  023,452 

September 678,062,976 

October 2,770,806,092 

November 3,394,416,518 

December 1,137,104,390 

iqiB 

January $1,525,984,729 

February 1,443,795,053 

March 1 ,993,080,060 

April 2,605.719,776 

'Figures  do  not  include  rediscounts  and  sales  of  discounttvl  paper  between 
Federal  Reserve  banks  nor  purchases  of  United  States  certificates  of  indebted- 
ness.   See  Report  of  the  Federal  Reserve  Board,  19 1 8,  pi).  19 1-93. 


274  FEDERAL  RESERVE  POLICY 

May 3.309,207, 1 1 1 

June 3.655.663,674 

July 3,490,037,616 

August 3.955.61 1,937 

September 4.953.969,540 

October 6,793,018,635 

November 5,569,708,767 

'The  following  table  shows  the  changes  in  the  reserve 
banks'  total  earning  assets,  member  banks'  reserve  ac- 
count, and  Federal  Reserve  notes  in  actual  circulation  for 
various  dates :  ^ 


000' S 

Omitted 

Federal  Reserve 

Member   Banks' 

Date 

Notes  in  Actual 

Reserve 

Circulation 

Account 

1917 

April  27 

$    239,260 

$    420,509 

$    719.785 

May  25 

287,297 

454.402 

813,326 

June  29 

494.536 

.       508,753 

1,033,460 

July  27 

411,978 

534.015 

1. 135.456 

August  31  .  .  .  . 

381,063 

587.915 

1,069,804 

September  28  . 

504.937 

700,212  j 

1,136,930 

October  26 ...  . 

684,959 

847,506 

1,264,323 

November  30  . 

1.052,377 

1,056,983 

1,489,370 

December  28 .  . 

1,064,310 

1,246,488 

1,453.166 

1918 

January  25  .  , . 

$1,029,670 

$1,234,934 

$1,480,743 

February  21  . . 

1.031,797 

1.314.581 

1,459,720 

March  28-29.  • 

1.201,585 

1.452.838 

1,499.400 

April  26 

1,286,162 

1,526,232 

1,497.416 

May  31 

1,301,390 

1,600,968 

1,440,413 

June  28 

I.345.II2 

1,722,216 

1,557,587 

July  26 

1,564,540 

1,870,835 

1,435,196 

August  30  ... . 

1,716,987 

2,092,708 

1,478,639 

September  27  . 

2,080,566 

2,349,326 

1.535.490 

October  25 ...  . 

2,295,122 

2,507,912 

1,683,499 

November  29  . 

2,312,359 

2,568,676 

1,488,893 

Some  surprise  may  be  evoked  by  the  fact  that  the 

growth  of  the  note  issues  was  so  much  greater  than  that 

of  the  book  credits  granted  to  member  banks.    This  is 

*  See  i^epor^  of  the  Federal  Reserve  Board,  1917,9.60;  1918,  pp.  122  and  117. 


DEVELOPMENT,  MAY,  1917,  TO  NOV.  11,  1918    275 

explained  in  large  measure,  however,  by  the  fact  that  the 
notes  were  being  substituted  for  gold  in  the  general  circu- 
lation. The  process  was  one  by  which  notes  were  issued 
to  meet  member  banks'  counter-money  needs  and  the 
gold  of  the  reserve  banks  was  being  deposited  with  the 
Federal  Reserve  agents  as  cover.  This  is  shown  by 
the  following  figures: 

Gold  Cover  for  Federal  Reserve  Note  Circulation  • 
(000,000's  Omitted) 
Date 
1917 
June  29 $   402 

July  27 434 

August  31 49-^ 

September  28 558 

October  26 614 

November  30 661 

December  21 746 

1918 

January  25 $    793 

February  21 877 

March  29 852 

April  26 824 

May  3 955 

June  28 987 

July  26 910 

August  30 •l.oiS 

September  27 1,161 

October  25 1,184 

November  29 1,216 

To  a  greater  and  greater  extent  the  country's  gold  was 

being  drawn  into  the  hands  of  the  reserve  agents  where, 

according  to  the  amendment  of  June  21,  19 17,  it  would  be 

counted  as  part  of  the  reserve  banks'  40  per  cent  required 

reserve.    By  this  process  other  gold  in  the  reserve  banks' 

vaults  was  released  to  serve  as  the  reserve  for  deposit 

grants  to  member  banks. 

'  See  Reports  of  the  Federal  Reserve  Board,  1917,  p.  47 ;  1918,  pp.  97,  98. 


276  FEDERAL  RESERVE  POLICY 

The  cfTcct  of  the  discount  operations  upon  reserve 
banks'  ratio  of  cash  reserve  to  net  deposits  and  notes  is 
next  indicated : 

Ratio  of  Total  Cash  Reserves  to  Net  Deposits  and  Federal 
Reserve  Notes' 

1917 

March  30 89.0 

June  29 75.4 

Augusts 81.9 

November  2 69.0 

December  28 63.6 

1918 

February  21 66.0 

April  19 62.9 

May  31 62.0 

July  I    59-8 

August  30 564 

November  22 50.5 

Great,  however,  as  was  this  reduction  in  the  reserve 
ratio,  it  would  have  been  much  greater  had  it  not  been  for 
the  new  accretions  of  gold  by  the  reserve  banks.  On  April 
5-6,  1917,  for  instance,  the  total  gold  holdings  of  reserve 
banks  (gold  in  vaults  plus  gold  with  foreign  agencies  plus 
Gold  Settlement  Fund  plus  gold  deposited  with  Federal 
Reserve  agents  as  cover  for  the  notes)  was  ^943,552,000. 
On  November  15,  1918,  this  total  was  ^2,056,777.  Credit 
and  currency  expansion  were  so  great  and  so  rapid  that 
the  huge  surplus  reserves  of  April  6,  1917,  would  have 
fallen  far  short  of  meeting  the  demands.  Only  the  attrac- 
tion of  gold  from  the  general  circulation  enabled  reserve 
banks  to  maintain  a  favorable  ratio.  As  it  was,  the  reserve 
ratio  fell  approximately  forty  per  cent  in  little  more  than  a 
year  and  a  half  of  hostilities. 

Let  us  next  ascertain  the  effect  of  the  war  upon  the 
operations  of  member  banks.   Between  May  i,  19 17,  and 

»  See  Reports  of  the  Federal  Reserve  Board,  1917,  p.  15;  1918,  pp.  9,  10. 


DEVELOPMENT,  MAY,  1917,  TO  NOV.  11,  1918    277 

November  l,  1918,  demand  deposits  of  all  national  banks 
responding  to  the  Comptroller's  call  ^  increased  from 
^7,618,011,000  to  ^8,640,818,000,  or  more  than  a  billion 
dollars.  Time  deposits  increased  in  the  same  pericxl  by  a 
sum  approaching  ^300,000,000.  Loans  and  discounts 
advanced  in  the  same  time  from  38, 75 1,679,000  to 
^10,096, 940,000,  or  approximately  one  and  a  quarter 
billion  dollars.  Total  resources  displayed  a  gain  of 
33,676,97^000. 

In  view,  however,  of  the  huge  increase  in  reserve  bank 
operations  some  surprise  may  be  evoked  because  the  in- 
crease of  member  bank  advances  was  not  even  more  large. 
Deposits  with  reserve  banks  comprise  the  legal  reserves 
for  member  banks.  Each  dollar  of  deposits  with  a  reserve 
bank  forms  the  legal  minimum  reserve  for  many  dollars 
of  its  own  deposits.  The  advances  of  reserve  banks  furnish 
the  basis  for  a  several-fold  expansion  in  member  bank 
operations. 

We  must  recall  the  effect,  however,  of  the  amendment 
of  June  21,  1917,  which  required  the  deposit  of  all  reserve 
money  with  reserve  banks.  As  country  banks  transferred 
their  funds  from  their  city  reserve  agents  to  the  reserve 
banks,  the  deposits  of  the  city  reserve  agents  diminished 
and  those  of  the  reserve  banks  increased.  For  instance, 
the  condition  of  reserve  banks  prior  to  the  amendment  is 
indicated  by  the  weekly  statement  of  June  22,  19 17.  On 
that  date  the  reserve  banks  due-to-members  account  was 
i58o6, 209,000.  The  final  transfer  of  reserves  was  com- 
pleted July  20,  19 1 7.  On  this  date  the  reserve  account  of 
members  had  increased  to  j?i,  164,995.  More  lliaii 
^350,000,000  of   reserve  bank  deposits  represented    the 

'  Sec  Comptroller's  Report,  IQ17,  vol.  i,  p.  35;  191.S,  vol.  I,  p.  16.  Fi!.,nires  for 
May,  1917,  aru  for  7,58<j  banks.  Tliosc  for  Novciiiber  i,  1918,  arc  for  7,754 
banks. 


278  FEDERAL  RESERVE  POLICY 

shifting  of  reserves  to  reserve  banks.  So  far  as  the  increase 
of  Federal  Reserve  note  issues  is  concerned,  it  has  been 
shown  that  they  represented  in  large  measure  the  sub- 
stitution of  notes  for  gold  in  the  general  circulation. 

An  increasing  volume  of  currency  and  credit  indicates 
one  of  several  results.^  First,  it  may  point  to  a  higher 
degree  of  industrial  and  business  activity.  If  the  general 
level  of  prices  remains  unchanged,  greater  production  and 
more  numerous  exchanges  necessitate  an  increased  circu- 
lation of  money.  Secondly,  the  increased  circulation  may 
indicate,  not  greater  economic  activity,  but  rather  a  higher 
price  level  at  which  exchanges  take  place.  Third,  the 
enlarged  circulation  may  indicate  changes  either  in  the 
amount  of  productivity  or  in  the  general  level  of  prices. 
Let  us  next  endeavor  to  ascertain  in  which  direction  the 
effect  was  felt  most  largely. 

The  figures  of  the  United  States  Bureau  of  Labor  Statis- 
tics *  show  an  enormous  rise  of  wholesale  prices  in  this 
period.  Considering  19 13  as  a  base  year  the  index  number 
of  wholesale  prices  for  all  commodities  advanced  as  follows : 

1917  1918 

April 172  January ....  185 

May 182  February  ...  186 

June 185  March 187 

July 186  April 190 

August 185  May 190 

September  . .  183  June 193 

October 181  ,  July 198 

November  .  .  183  August 202 

December. . .  182  September  .  .207 

October  .  . .  .204 
November  .  .  206 
'  No  account  is  taken  here  of  changes  in  the  rate  of  turnover  of  money.  Un- 
doubtedly money  was  becoming  more  efficient  in  this  period.  The  Gold  Settle- 
ment Fund  and  the  Federal  Reser\'e  Clearing  System,  for  instance,  lessened 
enormously  the  amount  of  money  required  to  effect  inter-bank  balances.   To 
the  extent  that  the  efficiency  of  money  was  increasing,  we  have  another  expla- 
nation of  the  rise  in  commodity  prices. 
'Bulktiti  No.  269,  July,  1920,  pp.  16-19 


DEVELOPMENT,  MAY,  1917,  TO  NOV.  11,  1918    279 

In  the  field  of  retail  prices  the  movement  for  the  same 
period  is  indicated  by  the  following  index  numbers  of  the 
Bureau  of  Labor  Statistics  representing  twenty- two 
articles  of  food :  ^ 

1913  =  100 
1917  1918 

April 145  January  ....  160 

May 151  February  ..  .161 

June 152  March  .  .    .  .  154 

July 146  April    154 

August 149  May 158 

September  ..  153  June 162 

October  ...  .157  July 167 

November  .  .155  August 171 

December   ..157  September    .178 

October  ...  .181 
November  .  .183 

Both  wholesale  and  retail  prices  displayed  an  excep- 
tionally large  advance.  Let  us  next  endeavor  to  ascertain 
whether  the  volume  of  trade  increased  in  anything  like  a 
similar  degree.  Figures  in  this  field  cannot  be  accepted 
with  so  much  confidence  because  the  increase  in  business 
activity  is  bound  up  with  that  of  increased  prices.  Bank 
clearings,  for  instance,  may  show  no  more  the  effect  of 
increasing  trade  activity  than  the  heightened  price  level 
at  which  exchanges  of  goods  and  services  were  made.  This 
problem  of  entangling  prices  from  the  volume  of  business 
has  been  most  successfully  attempted,  however,  in  statis- 
tics relating  to  the  production  of  raw  materials.  According 
to  figures  contributed  by  Professor  Wesley  C.  Mitchell, 
the  following  index  numbers  represent  changes  in  the 
production  of  ninety  commodities.  In  order  to  eliminate 
the  effect  of  the  change  in  the  price  level  the  value  of  all 
commodities  is  figured  on  the  basis  of  1917  prices.' 

'  Bulletin  No.  270,  February,  1921,  p.  27. 
'  Cf.  Bulktin,  April  i,  lyiy,  p,  337. 


28o  FEDERAL  RESERVE  POLICY 

Index  Number  of  all  Commodities 

Yearly  Production  Times  19 17  Prices 

1913 100 

1914 99 

1915 107 

1916 Ill 

1917 114 

1918 116 

These  figures  would  seem  to  indicate  that  the  with- 
drawal of  labor  to  the  field  and  camp  almost  overcame  the 
effect  of  speeding  up  industry  by  resort  to  the  devices  of 
more  complete  employment,  longer  hours  for  labor,  and 
the  bonus  system.  The  year  19 18  shows  only  a  slight 
increase  over  1917.  While  the  field  of  production  statistics 
has  received  little  attention  until  recently  these  results 
agree  sufficiently  closely  for  our  purposes  with  those  of 
otiier  statisticians.  Walter  W.  Stewart,  for  instance,  using 
19 13  as  the  equivalent  of  100,  shows  the  advance  in  1918 
over  1917  to  be  one  point  (125-124).^ 

These  facts  show  that  the  enlarged  media  of  exchange 
correlates  more  closely  with  the  rise  of  commodity  prices 
than  with  increasing  trade  activity.  We  may  next  inquire 
as  to  the  causal  relationship  between  the  increase  in  the 
media  of  exchange  and  the  advance  in  commodity  prices. 

It  is  clear  that  the  bond  method  of  war  finance  resulted 
in  an  increasing  money  demand  for  goods.  The  part 
played  by  the  banks  in  furnishing  funds  for  bond  pur- 
chases was  such  as  to  supply  the  means  whereby  the 
Government  and  the  consuming  public  were  brought  into 
sharp  competition  one  with  the  other.  The  Government 
was  given  credit  not  previously  in  existence,  and  this  credit 
was  employed  for  the  purchase  of  labor  and  materials.  So 
far  as  these  became  more  scarce  relative  to  the  demands 

'  Cf.  W.  W.  Stewart,  "An  Index  Number  of  Production,"  American  Economic 
Review,  March,  1921,  p.  68. 


DEVELOPMENT,  MAY,  1917,  TO  NOV.  11,  1918    281 

for  them,  the  individual  could  secure  them  only  by  offering 
higher  prices.  It  is  true,  however,  that  this  was  not  the 
result  of  all  types  of  Government  bond  purchases.  If  the 
individual  purchased  the  Government  bonds  out  of  sav- 
ings, no  enlarged  money  demand  for  goods  was  made 
possible.  Credit  previously  possessed  by  the  subscriber 
was  transferred  to  the  Government.  To  the  extent  that 
this  enabled  the  Government  to  offer  money  for  goods, 
the  individual's  demand  must  be  lessened.  The  Govern- 
ment merely  took  the  place  of  the  individual  and  the  con- 
ditions of  demand  were  not  greatly  altered. 

But  in  many  cases,  war  bond  subscriptions  resulted  in 
something  more  than  the  mere  transfer  of  existing  bank 
credit  from  the  bond  purchaser  to  the  Government.  If  the 
bond  was  bought  by  a  bank,  bank  credit  was  given  to  the 
Government,  but  loans  to  the  bank's  customers  need  not 
be  reduced.  In  case  of  a  shortage  of  loanable  funds,  the 
bank  had  merely  to  call  upon  the  reserve  bank  for  a  dis- 
count. In  such  a  situation  customers  of  the  bank  retained 
the  funds  they  possessed  before,  and  the  Government 
entered  the  market  with  new  credit  to  bid  for  goods. 

The  same  results  followed  when  the  individual  hypothe- 
cated his  bonds  with  his  bank  as  collateral  for  a  loan,  or 
purchased  the  bond  out  of  money  loaned  by  the  bank.  In 
these  cases  the  individual's  bank  account  was  not  corre- 
spondingly lessened  by  the  bond  purchase,  and  the  net 
result  of  the  transaction  was  to  furnish  the  Government 
with  dollars  in  such  a  way  as  not  to  lessen  the  bond  pur- 
chaser's ability  to  offer  dollars  for  goods.  Finally,  if  the 
bond  was  used  itself  as  a  medium  of  exchange,  it  operated 
in  much  the  same  way  as  Government  paper  money. 

The  effect,  however,  of  an  enlarged  monetary  demand 
for  goods  need  not  necessarily  result  in  higher  prices.  Tlie 
increased  demand  may  make  possible  production  on  a 


282  FEDERAL  RESERVE  POLICY 

larger  scale  in  such  a  way  as  to  lessen  per-unit  expenses. 
To  the  extent  that  competition  prevailed  in  the  industry, 
lower  production  costs  would  be  reflected  in  lower  prices. 

Slight  reflection,  however,  is  required  to  indicate  that 
this  could  not  have  been  the  usual  result.  In  order  to 
remove  labor  from  peace  to  war  industries,  the  Wcige  scale 
necessarily  had  to  be  advanced.  New  standards  of  labor 
remuneration  were  thus  established  which  unionized  labor 
insisted  upon  realizing  elsewhere.  The  tremendous  de- 
mand for  war  materials  made  it  necessary  throughout  the 
industrial  field  to  extend  production  to  the  relatively 
inefficient  plant.  There  was  much  work  for  the  marginal 
concern.  These  factors  seem  to  have  more  than  counter- 
balanced the  economies  occasionally  realized  of  large-scale 
production.  Enlarged  demand  necessitated  greater  per- 
unit  expenses  and  accordingly  higher  prices.  The  only 
means  of  preventing  such  a  result  would  have  been  to 
employ  a  method  of  war  finance  whereby  advances  of  bank 
credit  to  the  Government  could  be  made  only  by  lessening 
the  public's  command  over  dollars  of  credit  or  currency. 
The  bond  method  obviously  could  not  do  this. 

It  is  no  part  of  the  purpose  of  the  writer  to  elaborate  the 
objectionable  features  of  the  war-time  price  advance.  The 
difficulties  created,  particularly  for  the  unorganized 
worker,  the  bondholder,  public  utilities,  endowed  univer- 
sities and  hospitals,  in  general  for  the  recipients  of  rela- 
tively fixed  incomes,  have  been  sufficiently  elaborated  in 
popular  discussion.  It  is  fully  understood,  also,  how  the 
destruction  of  old  standards  of  fair  prices,  standards  which 
were  the  crystallization  of  past  competitive  conditions, 
made  it  virtually  impossible  for  the  consuming  public  to 
keep  a  close  check  upon  the  profiteer.  Labor  disturbances 
also  and  the  consequent  interference  withx.war  materials' 
production  were  frequently  attributable  to  the  worker's 


DEVELOPMENT,  MAY,  1917,  TO  NOV.  11,  1918    283 

unwillingness  to  submit  to  a  reduction  in  the  real  value 
of  his  wage.  Altogether,  price  inflation  enabled  a  small 
class  of  society  to  levy  undeserved  tribute  upon  the  other 
classes.  Profound  and  permanent  changes  in  the  social  and 
economic  structure  of  society  were  the  inevitable  results. 
Most  of  these  changes,  affecting  extremely  harshly  the 
middle  classes  and  the  organized  worker,  were  not  such  as 
to  render  easier  the  preservation  of  real  democracy  in  this 
country's  future. 

But  the  writer  would  prefer  to  emphasize  two  special 
aspects  of  the  war-time  price  increase.  In  the  first  place, 
it  rendered  more  difficult,  if  not  impossible,  the  satisfac- 
tory solution  of  many  international  as  well  as  of  domestic 
post-war  financial  problems.  Secondly,  it  retarded  the 
speedy  mobilization  of  this  country's  material  and  man- 
power for  war. 

It  was  clear  to  careful  observers  that  our  post-war 
requirements  would  be  such  as  to  necessitate  easy  money 
and  liberal  credits.  The  release  of  soldiers  from  field  and 
camp  and  the  cessation  of  work  in  the  munitions'  factories 
would  demand  the  rapid  return  of  these  men  into  indus- 
try. To  fail  to  secure  their  speedy  reentry  must  mean 
unemployment,  discontent,  and  unrest.  Accordingly,  the 
post-war  banking  policy  must  be  one  of  easy  money  rates 
and  liberal  credits.  The  banks  should  offer  this  stimulus 
to  industry  after  the  war. 

Every  dollar  of  credit  expansion  during  the  war  ren- 
dered this  post-war  relief  more  difficult,  however.  Even 
despite  the  sudden  cessation  of  hostilities  the  war-time 
advance  was  such  as  to  render  a  further  increase  almost 
unendurable  to  the  non -entrepreneurial  classes  of  society. 
As  it  was,  prices  got  further  out  of  line  with  each  other, 
and  the  inevitable  readjustment  was  rendered  more 
serious.    But  if  the  war-time  price  advance  could  have 


284  FEDERAL  RESERVE  POLICY 

been  retarded,  a  slight  post-war  increase,  made  px)ssible 
by  offer  of  liberal  bank  credits,  could  have  been  withstood 
with  comparative  ease. 

The  price  increase  of  the  war  period  rendered  more 
difficult  also  our  post-war  position  as  the  world's  banker. 
Despite  the  enormous  advances  to  Europe  made  in  the 
days  following  the  signing  of  the  armistice,  there  seems  no 
doubt  in  the  mind  of  the  writer  that  we  fell  far  short  of  the 
demands  upon  us.  This  should  not  be  construed  as  mean- 
ing that  we  did  not  loan  Europe  sufficient  sums  for  non- 
productive purposes.  On  the  contrary,  the  writer  feels 
that  one  of  our  greatest  mistakes  of  the  reconstruction 
days  was  our  failure  to  restrict  Europe's  purchases  to  the 
goods  needed  for  her  industrial  revival.  We  permitted 
her  to  dissipate  her  credit  in  the  purchase  of  luxuries  and 
consumption  goods  until  the  point  arrived  when  her  pur- 
chases must  necessarily  be  restricted.  Rather  suddenly, 
American  export  industries  lost  their  European  market. 
There  need  have  been  no  such  loss  of  this  foreign  market. 
If  Europe's  purchases  could  have  been  confined  to  ma- 
chinery, necessary  raw  materials,  production  goods  in 
general,  her  ability  to  continue  to  buy  from  us  need  not 
have  been  impaired.  The  resuscitation  of  her  industries 
would  have  enabled  her  in  time  to  purchase  our  goods 
through  offer  of  the  credits  established  throughout  the 
world  by  sale  of  the  products  of  her  revived  industries. 
But  as  it  was,  Europe  used  up  her  credit  quickly  without 
restoring  her  earning  power.  We  could  have  afforded  to 
loan  far  more  to  her  had  the  credits  been  used  for  wise 
reconstruction  purposes.  The  delay  of  reconstruction  in 
Europe  helped  to  usher  in  this  country's  depression  of 
1920-21. 

But  was  price  inflation  necessary  to  win  the  war?  Were 
not  bond  subscriptions  necessary  to  furnish  the  dollars 


DEVELOPMENT,  MAY,  1917,  TO  NOV.  11,  1918    285 

required  by  speedy  mobilization  and  rapid  war  prepara- 
tion? Were  not  cheap  rediscount  rates  necessary  to 
enable  banks  to  guarantee  their  customers  the  funds  for 
their  bond  subscriptions?  Could  the  twenty-odd  billions 
of  dollars  have  been  obtained  other  than  by  a  policy  of 
inflation? 

Nobody  would  argue  that  any  such  colossal  sum  of 
money  could  have  been  obtained  in  any  other  way.  If  our 
total  national  annual  income  prior  to  the  war  was  no  more 
than  fifty  billions  of  dollars,  for  which  estimate  there  is 
reputable  statistical  authority,  nothing  like  fifteen  or 
twenty  billions  a  year  could  have  been  obtained  by  taxa- 
tion or  borrowing  from  the  public's  savings.  Our  economic 
life  was  not  so  ordered  as  to  permit  the  devotion  of  one  half 
or  one  third  our  total  income  for  war  purposes.  The  only 
means  of  securing  such  a  stupendous  sum  lay  in  direct 
or  indirect  bank  advances.  But  under  this  method  each 
dollar  bought  less  than  would  the  dollars  contributed 
under  a  tax  or  huy-a-bond-out-oj-savings-only  programme. 

To  secure  the  speediest  mobilization  of  our  war  re- 
sources, the  funds  for  military  purposes  should  have  been 
obtained  from  the  existing  volume  of  money  and  credit. 
The  lessening  of  funds  expendable  for  peace  goods  would 
have  hastened  the  transfer  of  labor  from  the  industries  of 
peace  to  the  industries  of  war.  The  most  rapid  shifting 
could  be  compelled  only  by  lessening  that  portion  of  our 
income  stream  customarily  spent  for  civil  goods.  Credit 
and  currency  expansion  delayed  the  process  of  war 
mobilization. 

Since  the  war,  when  more  leisurely  reflection  is  possible, 
there  has  been  an  increasing  disposition  to  accept  these 
views.  But  these  views,  we  are  informed,  represent  judg- 
ment ascertained  after  instead  of  before  the  fact.  They 
indicate  only  the  hindsight  of  the  parlor  observer.  In  order 


286  FEDERAL  RESERVE  POLICY 

to  make  clear  the  writer's  position  in  this  matter,  he  would 
like  to  quote  from  an  article  prepared  by  him  in  the  winter 
of  1917-18  in  the  midst  of  our  warlike  preparations:  ^ 

To  what  purposes,  then,  should  the  reserve  banks'  surplus 
gold  be  put?  Should  it  be  used  at  the  present  time  to  enable 
member  banks  to  increase  their  loans  to  the  business  public, 
or  should  it  be  carefully  husbanded  to  meet  post-bellum  re- 
quirements? Now  is  the  time  when  this  question  of  policy  must 
be  met  squarely.  The  Board  that  controls  the  largest  surplus 
stock  of  gold  the  country  has  ever  held  surely  ought  not  to  con- 
tent itself  with  mere  day-to-day  decisions.  Let  the  maximum 
amount  of  credit  be  extended  to-day  and  heightened  commodity 
prices  will  render  this  gold  unavailable  for  later  purposes.  More 
bank  loans,  and  consequently  more  gold,  will  be  needed  to 
finance  the  same  volume  of  transactions.  Deflation  can  take 
place  only  slowly  and  gradually  and  with  resultant  depression 
to  business. 

In  the  minds  of  the  great  majority  of  the  people  the  Board 
can  make  but  one  choice.  We  are  reminded  that  the  present 
need  for  funds  exceeds  that  of  any  previous  period,  that  the 
gravity  of  the  war  situation  demands  that  every  possible  dollar 
be  used  to  meet  existing  requirements  regardless  of  any  oppor- 
tunities to  come.  National  defense,  we  are  told,  supersedes  all 
future  trade  advantages.  By  liberal  offer  of  its  credit  the  Board 
should  quicken,  therefore,  the  course  of  present  industry.  If 
inflated  prices  result,  these  must  be  accepted  as  part  of  our 
sacrifice  to  the  cause  of  democracy. 

Each  day,  however,  the  fallacy  of  this  view  grows  more  obvi- 
ous. It  is  becoming  clear  that  the  production  of  war  supplies  is 
fundamentally  not  a  problem  of  securing  dollars,  but  rather  one 
of  commandeering  labor  and  materials.  The  real  problem  of  war 
finance  is  to  shift  labor  and  equipment  with  the  least  possible 
delay  from  the  unessential  to  the  necessary  war  industries.  No 
matter  what  financial  programme  is  adopted,  it  is  clear  that  only 
by  restricting  the  operations  of  the  non-war  industries  can  there 
be  the  largest  possible  increase  in  the  production  of  military 

•Cf.  H.  L.  Reed,  "Credit  Expansion  under  the  Federal  Reserv^e,"  American 
Economic  Review,  June,  1918,  pp.  270-82. 


DEVELOPMENT,  MAY,  1917,  TO  NOV.  11,  1918    287 

supplies.  The  stream  of  purchasing  power  that  ordinarily  flows 
to  the  one  must  in  large  measure  be  transferred  to  the  other. 
The  quickest  transition  can  take  place,  not  by  increasing  the 
total  volume  of  bank  dollars,  but  by  diverting  dollars  from 
former  fields  of  expenditures.  The  funds  for  financing  war  indus- 
tries and  activities  should  be  obtained  in  largest  part  from  the 
existing  volume  of  money  and  credit. 

In  the  last  analysis  the  real  gain  from  economizing  our  gold 
does  not  arise  from  an  internal  expansion  of  credit.  By  virtue 
of  price  adjustment  domestic  industry  can  accommodate  itself 
either  to  a  large  or  to  a  small  volume  of  bank  credit.  The  ad- 
vantage of  refining  our  credit  system  results  rather  from  foreign- 
trade  operations.  To  support  our  credit  structure  with  less  gold 
releases  the  surplus  for  foreign  purchases,  virtually  enabling  us 
to  obtain  the  products  of  foreign  industry  without  the  expendi- 
ture of  labor  or  the  sacrifice  of  material  on  our  part.  To  the 
extent,  therefore,  that  foreign  countries  are  not  in  a  position  to 
sell  to  us  to-day,  our  surplus  gold  should  be  retained  for  post- 
bellum  needs.  In  the  measure  that  we  use  this  gold  at  the  pres- 
ent time  to  support  domestic  loans,  and  thereby  inflate  the 
general  level  of  prices,  we  lose  our  power  to  reap  the  final  and 
ultimate  gains. 

Inflation  is  sometimes  defended  on  the  ground  that 
rising  prices  have  a  stimulating  effect  upon  industry.  So 
much  accustomed  are  we  to  think  In  terms  of  dollars, 
rather  than  in  terms  of  their  purchasing  power,  that  an 
increase  of  money  Incomes  may  exert  a  favorable  psycho- 
logical effect  upon  business  and  labor.  As  David  Hume 
once  described  the  effect  of  the  gold  and  silver  discoveries 
of  the  sixteenth  century : ' 

Accordingly  we  find  that,  in  every  kingdom  into  which  money 
begins  to  flow  in  greater  abundance  than  formerly,  everything 
takes  a  new  face:  labor  and  industry  gain  life:  the  merchant 
becomes  more  enterprising,  the  manufacturer  more  diligent 
and  skillful  and  even  the  farmer  follows  his  plow  with  greater 
alacrity  and  attention. 

'  Essays,  Moral,  Political  and  Literary, 


288  FEDERAL  RESERVE  POLICY 

This  argument  was  scarcely  applicable,  however,  to  the 
period  of  our  participation  in  the  war.  Our  financial 
problem  was  as  much  to  repress  the  industries  of  peace  as 
to  stimulate  the  industries  of  war.  The  rising  prices  stimu- 
lated the  unnecessary  quite  as  much  as  the  necessary  war 
industries.  Rapid  preparation  for  war  could  come  only 
by  withdrawing  capital  from  the  industries  of  peace  at  the 
same  time  that  funds  were  being  made  available  for  those 
of  war. 

There  is  no  doubt  but  that  the  general  public  was  un- 
prepared for  heroic  financial  measures.  Our  patriotism  is 
a  curious  thing.  It  is  fit  that  men  be  conscripted  to  die 
upon  the  firing  line.  It  is  not  fit  that  there  be  conscription 
of  the  civilian's  income,  not  his  capital,  to  equip  the  sol- 
dier. Yet  those  who  resist  taxation,  the  logical  method  of 
transferring  funds  from  civil  to  war  expenditures,  are  the 
stuff  out  of  which  war  heroes  are  made !  We  seem  to  prefer 
to  bear  the  financial  burden  of  war  indirectly,  rather  than 
directly,  in  the  form  of  higher  living  costs.  But  this  sort 
of  a  sacrifice  is  most  inequitably  imposed  upon  the  people 
of  society. 

Would  it  have  been  possible,  however,  to  educate  the 
public  to  the  fact  that  the  bond  method,  in  the  same 
manner  as  any  other,  involves  a  real  burden  which  the 
public  cannot  shift  to  another  generation  by  borrowing 
from  its  own  people?  In  the  last  analysis  the  economic 
burden  of  war  consists  in  the  using  up  of  commodities  and 
human  services  for  purposes  of  destruction,  thus  lessening 
the  volume  of  production  for  civil  uses.  Selling  bonds  to 
its  citizens  does  not  mean  the  shifting  of  the  burden  to  a 
future  generation.  An  internal  debt  is  not  a  burden  for  a 
people  as  a  whole.  To  the  extent  that  some  are  taxed  to 
pay  the  interest  and  the  principal  of  the  bonds,  others 
benefit  by  receiving  these  taxes  in  the  form  of  bond  inter- 


DEVELOPMENT,  MAY,  1917,  TO  NOV.  11,  1918    289 

est  and  principal  repayment.  If  bonds  are  not  in  the  next 
generation  a  burden  upon  the  people  as  a  whole,  there 
could  be  no  shifting  of  the  burden  from  the  generation 
which  witnessed  the  conflict. 

It  may  be  that  it  would  have  been  impossible  to  secure 
general  confirmation  of  these  simple  economic  principles 
by  the  ordinary  processes  of  education  and  propaganda. 
But  if  so  great  attention  had  not  been  drawn  to  the  virtu- 
ally unlimited  supply  of  dollars  in  the  reserve  bank  reser- 
voirs, the  necessity  of  higher  taxes  and  more  restrictive 
rationing  methods  would  have  become  apparent  much 
more  early.  Gradually  we  should  have  seen  that  a  modern 
world  war  necessitates  financial  as  well  as  military  con- 
scription. But  the  part  played  by  our  public  authorities 
was  such  as  to  deaden  our  perception  of  these  facts.  We 
were  encouraged  to  buy  bonds  on  such  terms  as  inevitably 
to  create  price  inflation.  Individual  subscribers  were 
offered  funds  indirectly  obtained  from  the  Federal  Re- 
serve; banks  virtually  were  informed  that  they  would  be 
protected  by  the  Federal  Reserve  banks  against  over- 
subscription on  their  own  part  or  on  the  part  of  their  cus- 
tomers. Everything  possible  was  done  to  lull  instead  of  to 
arouse  a  spirit  of  critical  analysis  by  the  public. 

But  what  was  the  responsibility  of  the  Federal  Reserve 
administration  in  all  this?  Should  the  Federal  Reserve 
Board  have  refused  to  cooperate  with  the  Treasury? 
Should  it  have  based  its  rediscount  policy  upon  general 
banking  and  financial  considerations  alone  and  have 
ignored  the  Government's  fiscal  programme?  Should  the 
reserve  banks  have  ignored  the  bond  issues  in  the  forma- 
tion of  their  discount  policies? 

Only  slight  consideration  is  required  to  indicate  the 
undcsirability  of  any  hostile  attitude.  During  time  of  war 
the  various  governmental  agencies  cannot  refuse  mutual 


290  FEDERAL  RESERVE  POLICY 

cooperation.  They  cannot  work  at  cross- purposes.  Con- 
gress had  sanctioned  the  bond  method  of  war  finance,  and 
the  treasury  undoubtedly  acted  in  accordance  with  the 
general  point  of  view  in  recommending  the  "  low  interest" 
policy.  When  Congress  enacted  the  Federal  Reserve  Act 
it  provided  specifically  for  ex-ofhcio  membership  on  the 
Board  of  the  Secretary  of  the  Treasury  and  the  Comp- 
troller of  the  Currency.  Was  not  this  the  expression  of  its 
desire  that  there  be  close  cooperation  between  the  Treas- 
ury and  the  reserve  banking  authorities? 

From  the  standpoint  of  political  expediency  it  would 
have  been  extremely  unwise  for  the  Reserve  Board  to  have 
refused  full  cooperation  with  the  Treasury.  From  the 
time  of  Andrew  Jackson  the  public  has  accepted  the  dic- 
tum that  the  management  of  a  central  banking  system 
must  consider  itself  a  servant  of  public  authority.  During 
the  World  War  it  could  not  have  established  for  itself  an 
independent  position. 

Whatever  responsibility  can  be  placed  on  the  shoulders 
of  the  Board,  therefore,  can  only  be  those  resulting  from 
its  encouragement  of  an  unsound  financial  policy.  The 
final  question  to  be  investigated,  therefore,  is  whether  or 
not  the  Board's  counsel  was  such  as  to  encourage  infla- 
tionary tendencies. 

There  Is  no  doubt  regarding  the  Board's  position  in  this 
matter.  Throughout  the  war  it  preached  the  doctrine  of 
conservation  of  credit  as  well  as  of  goods.  To  quote  from 
its  official  pronouncements  in  the  January  i,  1918, 
Bulletin :  * 

Events  are,  however,  every  day  making  it  clearer  that  the 

conservation  of  our  financial  strength  is  not  of  itself  sufficient 

to  ensure  the  successful  financing  of  the  war.    The  financing 

of  the  war  is  only  in  part  a  money  problem ;  in  very  large  part 

'  Pages  2,  3. 


DEVELOPMENT,  MAY,  1917,  TO  NOV.  11,  1918     291 

it  is  an  economic  problem  —  a  problem  of  conserving  the 
economic  as  well  as  the  financial  strength  of  the  Nation.  .  .  .; 

Nobody  should,  therefore,  consume  goods  except  to  the  extent 
that  their  consumption  is  necessary  to  maintain  health  and 
vigor ; 

Let  the  public  realize  that  it  is  more  respectable  in  such  war 
times  as  confront  us  to  be  seen  in  old  clothes  than  in  new  ones. 
Let  the  banks  tell  the  people  of  their  communities  and  their 
authorities,  the  mayors  and  governors,  that  this  is  not  the  time 
for  cities  to  be  spending  money  on  public  works.  .  .  .  ; 

...  it  must  nevertheless  be  our  constant  concern  to  keep 
every  dangerous  tendency  in  the  banking  situation  under  con- 
trol and  particularly  to  retard  the  too  rapid  expansion  of  bank- 
ing credit.  .  .  . 

The  efTectiveness  of  such  implorations  may  well  be 
questioned.  Spending  cannot  be  lessened  while  the  means 
of  spending  increase.  Nevertheless,  the  Board's  record, 
during  this  period,  was  clear.  Whatever  the  evils  of  the 
easy-money  policy  of  war  finance  the  responsibility  can- 
not be  laid  at  its  doors.  The  fault  was  that  of  the  Treas- 
ury, of  Congress,  and  of  the  people.  So  infrequently  does 
war  occur  that  the  requirements  of  successful  war  finance 
are  not  generally  understood.  No  nation  ever  taxed  itself 
sufficiently  highly  during  a  great  war.  Any  other  policy 
must  be  inflationary.  During  the  Civil  War  the  inflation 
was  a  matter  of  greenback  issues.  During  the  World  War 
it  was  a  matter  of  note  issue  and  bank  credit  expansion. 
But  throughout  this  period  the  reserve  l)anks  were  merely 
financial  instruments  through  which  the  Treasury  en- 
deavored to  accomplish  its  aims. 


CHAPTER  XV 

FEDERAL  RESERVE  DEVELOPMENT,  NOVEMBER  12, 

1918,  TO  MAY,  1920 
THE  PERIOD  OF  POST-WAR  CREDIT  EXPANSION 

After  the  signing  of  the  armistice,  the  industrial  outlook 
was  extremely  uncertain.  It  is  true  that  most  of  the  long- 
time forces  seemed  to  point  toward  the  early  resumption 
of  general  prosperity.  The  labor  and  the  materials  that 
had  been  utilized  for  war  purposes  would  now  be  available 
to  supply  our  normal  wants,  and,  moreover,  the  cessation 
of  hostilities  enabled  industries  to  be  freed  shortly  from  a 
host  of  restrictive  measures.  Gradually  embargoes  upon 
certain  articles  of  export  were  removed,  the  list  of  pro- 
hibited imports  reduced,  and  the  priority  rules  established 
under  the  rationing  policy  of  the  War  Industries  Board 
abandoned.  Shipping  was  increasing  in  quantity,  building 
and  construction  were  no  longer  to  be  discouraged  by 
public  authority,  and  the  war  restrictions  relating  to  the 
securing  of  investment  capital  for  private  enterprise  were 
repealed.  With  these  fetters  removed,  it  appeared  that 
the  general  economic  welfare  soon  would  improve.^ 

Expressions  of  confidence  frequently  overlooked,  how- 
ever, the  fact  that  in  our  existing  economic  society  indus- 
trial activity  depends  upon  the  volition  and  the  appraisals 
of  the  entrepreneur.  If  he  does  not  feel  the  situation  ripe 
with  profit-making  possibilities,  industrial  stagnation  is 
our  lot.  Instead  of  demobilization  increasing  the  more 
complete  utilization  of  our  labor  force,  it  might  mean 

'Gf.  H.  L.  Reed,  "The  ladustrial  Outlook,"  Journal  gf  Political  Economy, 
April,  1919,  pp.  225-40 


DEVELOPMENT,  NOV.  12,  19 18,  TO  MAY,  1920     293 

merely  the  recruiting  of  the  army  of  the  unemployed.  The 
essential  question  at  the  close  of  19 19  was  whether  or  not 
industrial  and  financial  conditions  were  such  as  to  arouse 
enthusiasm  on  the  part  of  the  entrepreneur. 

In  very  many  respects  the  situation  was  cloudy.  Money 
wages  of  the  laborer  had  increased  far  above  their  pre-war 
level  and  it  did  not  appear  that  they  could  be  reduced 
quickly.  Organized  labor  appeared  determined  to  hold 
what  it  considered  to  be  the  gains  of  the  war  period,  to 
insist  upon  the  prevailing  wage  scale  even  though  com- 
modity prices  should  fall  to  a  lower  level.  It  is  true  that 
the  manner  in  which  wages  were  increased  was  frequently 
such  as  to  offer  hopes  of  speedy  reduction.  The  elimina- 
tion of  extra  hours  of  labor  would  remove  the  necessity  of 
paying  high  rates  for  the  products  of  the  hours  of  greatest 
fatigue.  With  the  suspension  of  work  in  the  war  industries 
the  employer's  bargaining  power  would  be  still  further 
increased.  A  strike  could  take  place  only  in  a  situation 
where  many  unemployed  would  be  looking  on.  The  return 
of  soldiers,  moreover,  would  enable  the  employer  to  take 
his  pick  and  select  only  the  fit.  During  the  war,  labor  costs 
were  high,  not  merely  because  of  the  high  money  wages, 
but  also  because  employment  had  to  be  offered  to  the  most 
inefficient  of  the  labor  group.  Nevertheless,  there  was  the 
likelihood  that  the  life  of  the  soldier  had  been  such  as  to 
unfit  him  for  steady  work  in  monotonous  tasks.  War 
necessarily  creates  a  spirit  of  unrest  and  independence, 
not  consistent  with  strict  industrial  discipline. 

As  to  finding  markets  for  industry's  products  there 
appeared  to  be  much  less  uncertainty.  The  economies  of 
the  war  period  left  many  demands  unsatisfied.  Work  on 
the  roads,  on  buildings,  on  capital  equipment  of  various 
sorts,  could  not  continue  to  l)c  neglected.  In  the  course  of 
time  the  Government  demand  for  investment  funds  would 


294  FEDERAL  RESERVE  POLICY 

relax  and  enable  a  part  of  society's  income  stream  to  be 
rcdcvoted  to  the  purchase  of  neglected  goods  and  services. 

In  one  way  it  was  particularly  fortunate  that  a  large 
portion  of  our  soldiers  did  their  fighting  three  thousand 
miles  from  the  United  States,  and  that  many  months 
elapsed  before  all  of  them  could  be  returned  home.  In- 
dustry was  not  required  to  plan  for  the  immediate  absorp- 
tion of  all  of  these  millions.  Demobilization  began  with 
certain  special  units  in  this  country  and  was  extended 
gradually.  As  the  men  first  discharged  worked  their  way 
into  industry,  their  own  wages  would  help  to  create  the 
demand  for  the  production  of  other  goods.  By  the  time 
the  divisions  from  the  battle  front  returned,  industry 
might  be  revived  sufficiently  to  offer  them  general 
employment. 

From  the  banking  standpoint  the  situation  was  some- 
what more  hopeful.  At  the  close  of  hostilities  the  reserve 
ratio  of  the  reserve  banks  was  approximately  fifty  per 
cent.  It  would  appear  that  this  would  be  sufficient  to 
guarantee  ample  funds  for  a  moderate  volume  of  new 
financing.  It  was  true  that  the  expenditures  of  the  war 
had  not  terminated.  One  new  bond  issue  was  yet  to  be 
offered  to  the  public,  and  it  was  plain  that  for  some  time 
the  Treasury  must  appear  in  the  loan  market  as  a  bidder 
for  Investment  capital.  There  were  also  certain  possibili- 
ties of  a  considerable  drain  of  gold  from  the  reserve  bank 
reservoirs.  During  the  war  the  embargo  upon  gold  pre- 
vented us  from  balancing  our  indebtednesses  by  shipments 
of  the  money  metal,  particularly  to  the  neutral  countries 
of  Europe  and  to  certain  nations  of  the  Orient.  Unpaid 
balances  as  well  as  new  indebtedness  might  create  a  heavy 
demand  for  this  purpose.  It  might  be  that  our  inability 
to  collect  gold  from  the  warring  nations  of  Europe  might 
subject  us  to  a  loss  of  gold  even  though  our  g^cneral  trade 


DEVELOPMENT,  NOV.  12,  1918,  TO  MAY,  1920    295 

balance  was  favorable.   But  all  in  all  the  sudden  termina- 
tion of  hostilities  left  our  banks  in  fairly  good  shape. 

It  was  in  the  matter  of  prices,  however,  that  the  greatest 
uncertainty  existed.  There  was  grave  doubt  everywhere 
as  to  whether  the  war  level  could  be  maintained.  Un- 
doubtedly the  common  prediction  was  that  the  removal  of 
war  conditions  would  destroy  the  cause  of  the  high  prices, 
and  that  in  a  short  period  the  restoration  of  production 
would  bring  about  their  decline.  It  is  true  some  difficulty 
was  experienced  in  explaining  how  there  could  be  enhanced 
production  in  a  situation  of  tumbling  prices.  Would  not 
weakening  prices  destroy  the  entrepreneurial  incentive 
to  productive  activity?  The  general  feeling,  nevertheless, 
seemed  to  be  that  the  war  level  was  an  abnormal  level, 
and  that  normal  conditions  would  mean  the  return  of  the 
pre-war  level. 

Such,  for  instance,  was  the  prediction  of  Mr.  B.  M. 
Anderson.  To  quote  from  his  argument :  * 

The  belief  that  there  will  be  a  drastic  drop  in  prices  is  based 
on  obvious  conditions.  With  a  vast  volume  of  labor  rapidly 
being  discharged  from  munition  factories  the  world  over  to 
resume  the  production  of  normal  supplies;  with  steel,  copper, 
coal,  shipping  and  other  essentials  released;  with  50,000,000 
soldiers  returning  to  farms  and  factories,  there  will  be  an 
immense  increase  in  the  volume  of  goods  available  for  civilian 
consumption.  Prices  should  fall,  even  before  this  actual  trans- 
formation is  carried  far,  because  wholesale  markets  commonly 
forecast  impending  changes. 

It  must  be  admitted  that  the  price  movement,  shortly 
after  the  armistice,  tended  to  confirm  these  views.  The 
wholesale  price  index  of  the  Bureau  of  Labor  Statistics 
showed  for  December,   1918,  a  decline  in  the  clothing, 

'  "When  War  Ends  and  Prices  Drop,"  Economic  World,  November  23,  1918, 
p.  727- 


296  FEDERAL  RESERVE  POLICY 

metal,  and  chemicals  groups.*  Both  in  January  and  in 
February  the  index  for  all  commodities  fell  somewhat. 
The  first  two  months  of  19 19,  moreover,  displayed  a  de- 
cline in  the  index  number  of  retail  food  prices.^ 

In  the  belief  that  a  continuous  price  decline  was  in- 
evitable, certain  projects  were  launched  for  the  purpose  of 
hastening  the  return  to  the  "rock-bottom"  level,  the  level 
at  which  industry  could  figure  upon  the  immediate  revival 
of  activity.  No  positive  achievements  resulted  from  these 
projects,  but  there  was  no  disposition  to  impose  harsh 
restrictions  upon  industry.  The  Federal  Reserve  banks 
held  their  rates  low.  For  January,  1919,  the  average  rate 
charged  on  all  paper  discounted  by  the  reserve  banks  was 
4.18  per  cent  and  for  February  4.14  per  cent.^ 

In  a  short  time,  however,  it  appeared  that  predictions 
of  price  decline  were  not  to  be  fulfilled.  Both  in  March  and 
in  April  the  all  commodities  wholesale  index  of  the  Bureau 
of  Labor  Statistics  showed  a  slight  increase,  and  the 
expected  Mifhculties  of  finding  employment  for  the 
returned  soldiers  did  not  seem  insurmountable.  Undoubt- 
edly most  observers  were  amazed  at  the  rapidity  with 
which  industry  adjusted  itself  to  the  new  conditions.  It  is 
probable  that  not  one  tenth  as  much  discussion  was  heard 
of  the  problems  of  reconstruction  as  had  been  anticipated. 
The  May,  1919,  Bulletin  noted  that  price  recessions  had 
not  been  as  rapid  as  predicted.  It  stated  : '' 

What  Is  now  happening  seems  to  indicate  that  business  will, 
after  a  period  of  Initial  readjustment  in  prices,  proceed  upon  a 
level  not  far  removed  from  that  established  during  the  war, 
leaving  the  question  as  to  the  ultimate  level  of  prices  to  the 
future  and  to  more  slowly  acting  forces. 

'  See  Bulletin  No.  269,  July,  1920,  pp.  16-19. 

'  See  Bureau  of  Labor  Statistics,  Bulletin  No.  270,  February',  192 1,  p.  27.  Tlie 
index  numbers  are  made  up  of  the  prices  of  twenty-two  articles  of  footl. 
J  Report  of  the  Federal  Reserve  Board,  1919,  p.  176.  *  Page  411. 


DEVELOPMENT,  NOV.  12,  1918.  TO  MAY,  1920    297 

Various  were  the  explanations  which  were  offered  for 
this  unexpected  firmness  of  prices.  For  one,  the  foreign 
demand  for  our  products  proved  much  stronger  than 
anticipated.  Also  during  the  war,  the  prices  of  many 
commodities  had  been  held  artificially  low  by  the  price- 
fixing  activities  of  Government  agencies.  When  the 
restrictions  were  removed,  supply  and  demand  conditions 
were  such  as  to  exert  a  tendency  for  these  prices  to  move 
to  a  higher  point.  On  the  part  of  entrepreneurial  manage- 
ment there  was  undoubtedly  also  a  recognition  of  the  fact 
that  the  time  was  not  opportune  for  a  conflict  with  labor, 
that  since  labor  insisted  upon  a  high  level  of  money  wages 
it  would  be  best  for  the  time  being  to  proceed  upon  the 
assumption  that  wages  were  not  to  be  reduced.  Wages 
could  be  put  in  proper  relation  to  other  prices  by  per- 
mitting the  general  level  to  advance.  But  whatever  the 
correct  explanation,  it  was  recognized  generally  by  the 
spring  of  1 9 19  that  the  period  of  price  uncertainty  was 
over  and  that  the  industrial  barometer  pointed  toward 
increasing  activity. 

The  financial  events  of  the  following  year  are  now  well 
understood  in  their  general  outlines.  The  country  was  to 
experience  a  rise  in  prices,  an  expansion  of  currency  and 
credit,  and  a  boom  in  industrial  and  speculative  activity 
which  exceeded  by  far  even  that  of  the  war  period.  This 
is  indicated  by  the  following  facts: 

April  25,  1919,  the  reserve  account  of  member  banks 
with  reserve  banks  was  ^1,664,320,000.  April  23,  1920,  it 
was  ^1,859,062,000,  a  gain  of  nearly  ^200,000,000.  In  the 
same  period  the  circulation  of  Federal  Reserve  notes 
increased  more  than  ^500,000,000  and  earning  assets  over 
^800,000,000.  On  May  12,  1919,  the  Comptroller's  reports 
show  loans  and  discounts  for  7773  national  banks  to  be 
^9,904,821,000.    May  4,  1920,  7990  national  banks  pos- 


298  FEDERAL  RESERVE  POLICY 

sesscd  loans  and  discounts  of  ^12,288,582,000.  This  was  a 
gain  of  more  than  two  and  a  tliird  million  dollars.  The 
activity  on  the  stock  exchanges,  the  boom  in  security 
prices,  the  rise  of  call-money  rates  exceeded  past  prece- 
dent. In  the  field  of  wholesale  prices  the  movement  was 
as  follows: 

Bureau  of  Labor  Statistics'   Index  Numbers  of  Wholesale 
Prices  for  All  Commodities.  Base  1913  =  100 

1917-March 161 

1918-March 187 

1919-March 201 

April 203 

May 207 

June 207 

July 219 

August 222 

September 221 

October 222 

November 230 

December 238 

1920— January 248 

February 248 

March 253 

April 266 

May 272 

In  view  of  the  fact  that  this  currency  and  credit  expan- 
sion was  so  great  as  to  cause  the  reserve  ratio  to  fall  from 
71.7  per  cent  on  May  2,  1919,  to  43  per  cent  on  May  7, 
1920,  and  that  on  many  occasions  the  New  York  Reserve 
Bank's  ratio  ^  was  on  the  margin  of  falling  below  the  legal 

'  A  slight  change  in  the  method  of  computing  reserve  banks'  reserve  ratio  was 
introduced  February  12,  1920.  Regarding  this  the  January',  1920,  Bulletin 
(p.  3)  states:  "Beginning  with  February  12,  1920,  the  reser\-e  to  be  carried  by 
Federal  Reserve  Banks  against  deposits  will  be  computed  against  immediately 
available  deposits  only.  Items  on  the  liability  side  whose  availability  is  deferred 
and  uncollected  items  on  the  resource  side  of  the  bank  statement  will  be  dis- 
regarded in  determining  the  liability  upon  which  reserve  is  computed.  This 
action  will  tend  to  apply  a  more  severe  standard  of  computation,  especially  in 
the  case  of  those  banks  which  have  been  carrying  a  relatively  large  float. " 


DEVELOPMENT,  NOV.  12,  1918,  TO  MAY,  1920    299 

minimum,  some  astonishment  may  be  evoked  because  the 
reserve  administration  permitted  this  enormous  expansion 
of  credit  and  currency.  It  should  be  emphasized  that  this 
expansion  rendered  possible  an  unexampled  ^  price  in- 
crease in  time  of  peace.  It  had  generally  been  expected 
that  the  post-war  era  would  witness  an  attempt  to  return 
to  pre-war  conditions.'  As  stated  in  the  Bulletin  for 
March,  1919:  ^ 

The  era  of  inflated  prices  maintained  by  aid  of  legislation  or 
by  Government  administrative  action  thus  draws  to  a  close,  and 
the  aim  to  be  sought  is  not  that  of  perpetuating  war  conditions, 
but  that  of  returning  to  a  stable  footing  upon  the  terms  and  con- 
ditions that  would  be  just  and  fair  to  all  concerned.  There  is 
much  agreement  with  the  Secretary  of  the  Treasury  in  his 
statement  that  the  readjustment  must  begin  with  a  reduction 
in  the  cost  of  living  to  the  consumer,  sorely  tried  as  the  latter 
has  been  by  the  great  inflation  of  prices  and  the  additions  made 
to  his  living  costs  in  many  directions. 

It  should  be  kept  in  mind,  furthermore,  that  in  the  latter 
part  of  1919  many  speculative  excesses  were  commonly  at- 
tributed to  the  rapid  growth  in  the  volume  of  bank  credit. 

Explanation  of  the  credit  policy  of  the  reserve  adminis- 
tration may  be  attempted  by  considering  the  following 
suggestions : 

First,  the  short-time  fiscal  requirements  of  the  Govern- 
ment were  such  as  to  cause  the  Treasury  to  demand 
easy  money  rates. 

Secondly,  there  was  the  fear  that  higher  rates  would 
work  a  hardship  upon  the  holders  of  the  war  bonds  by 
depressing  further  the  market  price  of  their  securities. 

Thirdly,  it  was  believed  that  easy  credits  were  neces- 

'  Unexampled  in  this  country  since  the  Rroenback  era. 
» As  stated  in  the  previous  chapter,  the  writer  docs  not  believe  this  would  have 
been  good  policy. 
J  Page  191. 


300  FEDERAL  RESERVE  POLICY 

sary  to  enable  industry  to  readjust  itself  quickly  to  the 
new  conditions. 

Fourthly,  there  was  a  failure  to  perceive  the  correct 
relation  between  expanding  credits  and  rising  prices  in  a 
period  of  great  industrial  activity.  The  theory  was  appar- 
ently accepted  that  prices  were  determined  by  other  forces 
than  the  volume  of  currency  and  credit. 

Fifthly,  a  restriction  of  credits  would  have  been  politi- 
cally unpopular.  The  public  does  not  understand  the 
necessity  of  restraint  in  the  manufacture  of  bank  credit. 
Its  complaints  are  directed  most  largely  against  the  results 
of  an  unduly  rapid  expansion  and  not  against  the  expan- 
sion itself. 

Sixthly,  there  was  much  doubt  as  to  the  effectiveness  of 
the  weapons  possessed  by  reserve  banks  to  curb  continu- 
ous increases  in  the  reserve  banks.  In  no  previous  period 
of  Federal  Reserve  operation  had  restrictions  been  em- 
ployed vigorously.  Precedent  and  experience  were  lacking. 

In  regard  to  the  short-time  fiscal  requirements  of  the 
Treasury,  it  will  be  recalled  that  the  Victory  notes  were 
issued  in  the  spring  of  19 19,  and  that  in  the  succeeding 
months  the  Treasury  continued  to  meet  its  current  re- 
quirements by  selling  low-interest-bearing  short-time 
certificates.  To  have  increased  rediscount  rates  on  paper 
collateraled  by  these  issues  would  have  rendered  their  sale 
difficult.  It  will  always  be  a  grave  question  as  to  whether 
the  continuation  of  the  low-interest  policy  was  justified. 
Despite  the  depreciation  of  the  dollar,  it  is  probable  that 
such  a  policy  was  to  the  immediate  advantage  of  the 
Treasury.  Since  a  large  portion  of  the  Government's 
disbursements  were  fixed  in  terms  of  dollars,  its  expendi- 
tures did  not  increase  proportionately  with  the  decline  in 
the  value  of  the  dollar. 

Wliether  or  not  there  was  warrant  for  subordinating 


DEVELOPMENT,  NOV.  12,  1918,  TO  MAY,  1920    301 

banking  considerations  to  Treasury  requirements  is  an- 
other matter.  But  as  the  situation  developed  it  was  not 
until  after  January,  1920,  when  the  Treasury  gave  up  its 
policy  of  floating  certificates  at  abnormally  low  rates,  that 
considerations  of  banking  policy  became  the  controlling 
factor. 

But  Government  finance  exerted  its  influence  in  other 
guise  than  in  the  Treasury's  short-term  requirements.  It 
was  understood  that  the  market  quotations  ot  war  bonds 
must  be  further  depressed  if  rediscount  rates  were  in- 
creased. If  member  banks  could  not  rediscount  paper 
collateraled  by  war  bonds,  the  banks  could  not  carry  the 
subscribers  without  loss.  Was  not  the  Government  mor- 
ally obligated  to  protect  those  who  had  heeded  its  call  to 
borrow  and  buy  bonds? 

Thorough  analysis  seems  to  indicate  that  there  was  no 
possible  manner  in  which  the  interests  of  these  bondhold- 
ers could  be  protected  fully.  Bond  prices  could  be  upheld 
only  by  a  policy  of  inflation.  But  inflation  meant  a  de- 
cline in  the  purchasing  power  of  the  dollars  realized  by  the 
sale  of  the  bonds.  What  if  they  did  sell  near  par?  The 
proceeds  would  purchase  less  and  less  either  in  other  secur- 
ities or  in  goods,  the  greater  the  depreciation  in  the  pur- 
chasing power  of  the  dollar.  In  other  words,  the  sacrifice  of 
the  bond-buyer  in  purchasing  low  interest  securities  must 
mean  loss  to  him.  No  policy  of  inflating  to  keep  money 
rates  low  could  avoid  this  loss.  Only  an  ease  in  the  money 
market,  determined  freely  and  without  artificial  control, 
could  aid  him. 

Those  connected  with  the  Treasury  have  not  hesitated, 
however,  to  defend  its  policy  on  the  ground  of  war  neces- 
sity. To  quote  from  R.  C.  Leflingwell,  Assistant  Secretary 
of  the  Treasury :  ^ 

'  See  American  Economic  Review,  March,  192 1,  pp.  30-36. 


302  FEDERAL  RESERVE  POLICY 

During  the  whole  period  of  the  war  any  attempt  of  the 
Federal  Reserve  Board  to  control  credit  through  rates  would 
have  been  futile.  The  Treasury  would  have  had  to  meet  any 
rate  they  made  at  home,  and  the  federal  reserve  bank  rate  could 
have  no  efTect  upon  the  international  situation,  because  the 
international  movements  of  goods,  gold,  and  capital  was  con- 
trolled by  foreign  governments  or  our  own  for  the  purposes  of 
the  war.  The  adoption  of  a  "dear  money"  policy  during  the 
war,  with  a  view  to  preventing  inflation  would  have  failed  of 
that  purpose  unless  it  had  been  carried  to  such  an  extreme  as  to 
bring  about  such  conditions  in  war  time  as  exist  to-day,  in  which 
case  we  should  have  lost  the  war  and  would  have  had  to  inflate 
afterwards  in  order  to  pay  the  indemnity  which  Germany  would 
have  imposed  upon  us. 

If  Lefftngwell  means  by  this  that  a  higher  rate  on  bonds 
would  not  have  enabled  the  Government  to  obtain  many 
more  dollars  from  the  bond  subscriber,  we  may  express 
agreement.  To  a  very  large  extent  considerations  of 
interest  and  income  were  ignored  by  the  bond-buyer  in 
the  making  of  his  subscription  and  a  higher  rate  might  not 
have  attracted  greater  purchases.  No  matter  what  the 
rate,  the  national  income  was  not  large  enough  to  permit 
a  large  portion  of  the  subscriptions  to  be  made  from 
savings.  Banks  were  obliged  to  advance  a  large  part  of 
the  funds,  expecting  individual  subscribers  to  take  them 
up  at  a  later  date.  But  to  the  extent  that  these  considera- 
tions are  true,  we  have  another  argument  against  relying 
upon  borrowing  as  the  chief  means  of  securing  war  reve- 
nues. At  an  earlier  date  heavier  taxation  would  .have 
aided  the  process  of  speedy  mobilization  and  would  have 
confined  the  financial  disturbances  more  largely  to  the 
period  of  hostilities. 

But  to  continue  Lefftngwell's  statement: 

After  the  war  was  over  in  the  fighting  sense,  it  went  right  on 
in  the  Treasury  sense.  We  reached  the  peak  of  expenditures  in 


DEVELOPMENT,  NOV.  12,  19 18,  TO  MAY,  1920    303 

the  three  months,  November  and  December,  1918,  and  January, 
1919.  We  spent  two  billion  dollars  a  month.  That  was  as  much 
as  the  First  Liberty  Loan  each  month.  Since  armistice  day 
this  Government  has  paid  out  as  much  as  before  armistice  day, 
twenty  billions  before  and  twenty  billions  after.  The  gross  debt 
of  the  Government  on  armistice  day  was  eighteen  billions.  Nine 
months  later  it  was  twenty-six  and  a  half  billions.  While  the 
Government  debt  was  mounting  thus,  the  same  condition 
continued  which  had  existed  during  the  period  of  active  warfare. 
It  was  no  more  practicable  to  exercise  control  of  credit  by  the 
use  of  dear  money  than  it  had  been  before.  Indeed,  it  was  less 
practicable,  because  the  enthusiasm,  devotion  and  self-sacrifice 
of  the  American  people  while  war  was  on  vanished  over  night 
with  the  signing  of  the  armistice.  The  bills  did  not  get  paid  any 
easier,  but  a  good  deal  harder,  because  the  Germans  had 
capitulated. 

And  further: 

Though  something  may  be  said  for  the  view  that  in  the  latter 
part  of  1919  there  might  have  been  a  somewhat  earlier  and 
greater  advance  in  rates  on  commercial  paper  and  in  the  open 
market  buying  rates  for  acceptances,  my  own  judgment  is  that 
this  is  a  question  of  detail  rather  than  of  substance,  and  that  the 
elTort  to  make  money  really  dear  before  January,  1920,  when  the 
Government  was  first  able  to  reduce  its  floating  debt  to  manage- 
able amounts  and  maturities,  would  have  risked  more  than  it 
could  have  hoped  to  gain. 

The  undesirability  of  any  pronounced  increase  in  re- 
discount rates,  as  well  as  in  the  rates  borne  by  the  Treas- 
ury certificates  in  the  post-war  period,  seems  clear  to  the 
writer.  But  the  matter  of  a  slight  increase  at  a  date  prior 
to  the  fall  of  19 19  appears  to  be  something  more  than  a 
mere  matter  of  detail.  While  the  enhanced  cost  of  bank 
credit  in  and  of  itself  might  not  have  been  of  great  effect 
upon  industry  it  would  have  furnished  the  most  forcible 
statement  possible  of  the  reserve  administration's  dis- 
content with  the  existing  situation,  and  of  its  purpose  to 


304  FEDERAL  RESERVE  POLICY 

restrict  credits  as  soon  as  the  condition  of  the  Treasury 
made  such  action  possible.  It  might  have  prevented  so 
thin  a  stretching  of  the  speculative  bubble.  Despite  the 
warnings  of  the  Federal  Reserve  Board  and  of  the  reserve 
bank  directorates,  very  many  came  to  look  upon  the 
reserve  system  in  the  wrong  light.  For  the  first  time  in  the 
period  of  reserve  operation,  rcdiscounting  began  to  be 
considered  generally  as  primarily  a  means  of  securing 
funds  for  profit-making  opportunities.  As  stated  by  the 
Board  in  its  April,  19 19,  Bulletin:  ^ 

Already  some  well-managed  member  banks  are  showing  in 
their  statements  the  extent  to  which  they  are  in  debt  to  Fed- 
eral Reserve  Banks.  It  has  been  the  opinion  of  the  Board  that 
the  borrowing  of  member  banks  at  Federal  Reserve  Banks 
might  very  easily  be  carried  to  excess,  the  loans  being  placed 
there  primarily  for  the  purpose  of  profit  and  not  for  any  more 
general  public  or  fundamental  object.  In  a  general  letter  to 
banks,  issued  on  November  19,  (1918),  and  referred  to  in  the 
Federal  Reserve  Bulletin  for  December,  the  Board  took  occasion 
to  caution  member  banks  which  it  was  thought  were  in  some 
danger  of  overdoing  their  rediscounting,  that  the  purpose  of 
such  rediscount  operations  was  not  primarily  that  of  assisting 
the  member  institutions  which  placed  the  rediscount  to  obtain 
the  funds  for  further  profitable  operations,  but  was  rather  to  be 
determined  upon  the  basis  of  general  banking  advantage  or 
upon  that  of  relief  for  banks  which  found  themselves  hard 
pressed  or  were  suffering  from  reductions  in  reserve  account. 

The  writer  does  not  believe,  however,  that  such  warn- 
ings as  these  were  interpreted  very  seriously.  Without 
positive  action  in  the  form  of  rate  increases  they  seem  to 
have  been  regarded  merely  as  indicative  of  the  Board's 
viewpoint,  a  viewpoint  not  likely  to  warrant  coercive 
measures.  The  crisis  of  1920-21  was  due  to  many  causes. 
One  of  these  was  excessive  commodity  speculation  which 

•Page  311. 


DEVELOPMENT,  NOV.  12,  1918,  TO  MAY,  1920    305 

was  fanned  by  the  belief  that  credits  would  continue  to 
remain  cheap.  The  only  way  to  dissipate  this  belief  would 
have  been  to  raise  rates  before  the  bull  movement  had 
spread  far. 

An  increase  of  a  half  per  cent  or  so  on  the  Treasury's 
short-term  borrowings  would  not  of  itself  have  been  an 
important  consideration.  A  few  millions  of  extra  charges 
would  have  been  a  negligible  consideration  compared  with 
the  losses  suffered  by  this  country  in  the  industrial  collapse 
of  1920-21 .  Part  of  these  losses  might  have  been  prevented 
by  initiating  at  an  earlier  date  a  policy  of  rate  increases. 

Strengthening,  however,  the  view  that  rates  should  be 
kept  low  was  the  desire  to  enable  industry  to  readjust 
itself  quickly  to  new  conditions.  It  was  a  matter  of  supply- 
ing the  stimulus  of  easy  credits.  Not  until  the  summer  of 
19 19  was  there  manifested  any  strong  disposition  to  look 
at  the  matter  from  the  standpoint  of  the  consumer's 
interests.  In  the  general  demand  for  lower  living  costs 
which  followed  the  Railway  Brotherhoods'  insistence  that 
either  their  wages  should  be  increased  or  the  cost  of  living 
lowered,  there  was  manifested  a  general  inclination  on  the 
part  of  those  prominent  in  the  reserve  administration  to 
lay  the  emphasis  upon  the  necessity  of  wage  revision 
rather  than  upon  a  reduction  in  prices.  Mr.  A.  C.  Miller, 
a  member  of  the  Federal  Reserve  Board,  declared,  for 
instance,  that 

Some  mechanism  by  which  wages  may  promptly  be  adjusted 
to  changes  in  the  cost  of  living  must  be  accepted  as  an  essential 
part  of  the  American  wage  system.' 

He  did  not  state  what  should  be  done  to  relieve  the  recipi- 
ent of  a  fixed  income,  the  bondholder,  the  bank  depositor, 
the  endowed  university  or  hospital. 

»  Cf.  Bulletin,  October  i,  1919,  p.  915. 


3o6  FEDERAL  RESERVE  POLICY 

Prior  to  the  cost-of-living  controversy  in  the  summer  of 
1919  there  had  been  no  clear  statement  of  the  Board's 
position  regarding  the  relation  of  an  increasing  volume 
of  currency  to  the  general  level  of  prices.  But  on  August  8, 
1919,  in  a  letter  replying  to  an  inquiry  of  the  Senate  Com- 
mittee of  Banking  and  Currency,  Governor  Harding 
expressed  his  views  on  this  question.  To  quote  a  brief 
extract  from  Governor  Harding's  statement :  ^ 

The  difficulty,  indeed  the  impossibility,  of  keeping  in  circu- 
lation an  excessive  volume  of  Federal  Reserve  notes  should  be 
understood.  .  .  .  They  are  issued  only  as  need  for  them  devel- 
ops, and  as  they  become  redundant  in  any  locality  they  are 
returned  to  the  Treasury  at  Washington  or  to  a  Federal  Reserve 
bank  for  redemption.  Thus  there  cannot  be  at  any  time  more 
Federal  Reserve  notes  in  circulation  than  the  needs  of  the  coun- 
try at  the  present  level  of  prices  require. 

In  other  words,  the  volume  of  note  issues  depends  upon 
the  height  of  prices.  Instead  of  the  volume  of  currency 
determining  the  general  level  of  prices,  it  is  a  matter  of  the 
level  of  prices  determining  the  height  of  the  price  level. 

Because  the  increase  in  circulation  of  notes  had  exceeded 
the  increased  grants  of  book  credit  to  member  banks, 
Harding's  communication  dealt  almost  entirely  with  note 
issues.  It  appears  to  the  writer,  however,  that  the  same 
position  must  be  taken  regarding  deposit  credits  granted 
by  member  banks.  The  underlying  theory  of  Federal 
Reserve  note  issues  was  that  the  notes  should  be  emitted 
under  regulations  more  similar  to  those  governing  deposits. 
In  reality  the  nature  of  the  note  and  the  deposit  are 
identical.  They  both  represent  ways  by  which  banks  may 
create  credit  or  credit  money.  It  is  true  that  the  note 
possesses  a  greater  circulation  power  and  is  needed  by 
banks  to  avoid  losing  reserve  money  on  occasions  when 

'  Bulletin,  August  i,  1919,  p.  699  ff. 


DEVELOPMENT,  NOV.  12,  1918,  TO  MAY,  1920    307 

there  is  a  drain  on  counter  money.  But  so  far  as  their 
effect  on  prices  is  concerned,  and  that  is  the  question  now 
under  discussion,  both  must  be  regarded  as  part  of  the 
general  circulating  medium. 

If  this  theory  be  true,  that  the  volume  of  the  circulating 
medium  depends  upon  the  height  of  prices,  the  reserve 
administration's  responsibility  would  appear  to  be  lessened 
considerably.  It  never  could  issue  more  Federal  Reserve 
notes  than  the  "needs  of  the  country  at  the  present  level 
of  prices  require."  Its  policy  in  creating  credits  or  cur- 
rency could  never  be  attacked.  Prices  are  determined  by 
other  factors  and  other  causes,  without  direct  regard  to 
the  acts  of  the  reserve  administration. 

Since  this  theory,  if  accepted,  would  relieve  the  Board 
of  many  attacks  and  adverse  criticisms,  it  is  not  surprising 
that  the  Board  was  inclined  to  emphasize  it.  But  is  it 
true? 

Viewed  superficially,  the  theory  appears  to  be  correct. 
Every  business  man  knows  that  there  are  countless  trans- 
actions in  which  prices  are  agreed  upon  first,  and  that  the 
bank  credit  to  satisfy  the  purchaser's  indebtedness  is 
granted  later.  In  such  situations  it  appears  that  the 
height  of  prices,  independently  fixed,  determines  the  vol- 
ume of  credit  later  to  be  created.  But  what  led  our  buyer 
let  us  say  a  retail  dealer,  to  agree  to  pay  such  and  such  a 
price?  The  principal  consideration  was  whether  so  high  a 
price  must  be  paid  to  get  the  goods,  and  whether  the 
demand  of  consumers  would  be  sufficiently  strong  to  en- 
able him  to  unload  at  a  profit.  It  requires  but  a  moment's 
analysis  to  demonstrate  that  both  of  these  factors  arc 
subject  to  influence  by  the  banks  in  their  grants  of  credit 
to  the  business  public. 

Why  did  our  dealer  agree  to  pay  the  stipulated  price? 
Obviously,  because  the  seller  of  the  goods  could  obtain  a 


3o8  FEDERAL  RESERVE  POLICY 

favoral)lc  price  elsewhere.  What  enabled  other  dealers  to 
bid  up  prices  for  the  goods?  Obviously,  it  was  a  matter  of 
the  general  volume  of  currency  or  credit  at  their  command. 
In  the  creation  of  this  credit,  the  banks  elsewhere  played 
their  part  in  determining  the  strength  of  the  outside  com- 
petitive demand.  If  they  had  been  more  illiberal  in  their 
advances,  our  buyer  could  not  have  been  compelled  to 
offer  so  high  a  price. 

It  is  also  clear  that  banks*  advances  help  to  determine 
the  terms  on  which  the  dealer  can  unload  his  goods.  The 
credit  first  advanced  to  him  in  the  making  of  a  purchase 
is  gradually  diffused  throughout  all  classes  in  society. 
From  the  hands  of  the  retailer  it  is  passed  successively, 
perhaps,  into  the  hands  of  the  wholesaler,  wage-earner, 
and  landowner.  It  thus  helps  to  determine  the  intensity 
of  the  money  demand  of  consumers  for  the  goods. 

But  even  if  the  effect  of  this  advance  of  credit  upon 
supply  and  demand  conditions  elsewhere  is  ignored,  it  is 
clear  that  the  price  our  dealer  will  pay  will  be  influenced 
by  his  knowledge  of  the  bank's  attitude  toward  his  re- 
quests for  credit.  In  making  credit  available  for  the  dealer, 
the  bank  exerted  an  influence  upon  the  money  demand  for 
the  goods. 

The  writer  does  not  mean  to  argue  that  there  are  no 
limitations  upon  banks'  ability  to  affect  the  price  level  by 
the  liberality  of  their  credit  grants.  Under  certain  con- 
ditions, particularly  those  of  declining  confidence  in  the 
future  stability  of  the  market,  banks'  discount  policies 
may  hav^  little  effect  on  market  prices.  Bank  credit  can- 
not be  forced  upon  a  reluctant  business  community.  But 
in  a  situation  of  increasing  business  confidence  and  rising 
markets,  of  business  activity  and  commodity  speculation, 
such  a  situation  in  fact  as  that  of  the  summer  and  fall  of 
19 19,  banks  did  hold  the  key  to  the  situation.   They  fur- 


DEVELOPMENT,  NOV.  12,  1918,  TO  MAY,  1920    309 

nished  the  credits  which  enabled  buyers  to  shove  up  prices 
in  their  eager  desire  to  get  goods  quickly. 

As  indicated  in  the  previous  chapter/  however,  an  en- 
larged money  demand  does  not  always  bear  as  its  prin- 
cipal fruit  higher  prices.  The  enlarged  money  demand  may 
enable  the  scale  of  production  to  be  increased  on  terms  of 
lower  per-unit  costs.  To  quote  from  the  writer's  statement 
•  in  another  connection : " 

Suppose  the  situation  is  one  in  which  additional  labor  and 
materials  are  easily  available,  that  new  orders  need  not  necessi- 
tate enlargements  of  plants  or  changes  in  equipment.  Larger 
production  may  create  possibilities  of  economy  in  the  amount 
of  overhead  or  fixed  charges  allocated  to  each  unit  of  output. 
If,  under  these  circumstances,  retailers  are  stimulated  to  a 
reasonable  extent  by  information  that  the  required  credit  will 
be  forthcoming,  prices  are  not  necessarily  disturbed.  As  a 
matter  of  fact  they  may  even  be  lowered  in  that  the  retailers* 
orders  may  make  possible  production  under  conditions  of  greater 
efficiency.  It  may  no  longer  be  a  matter  of  setting  up  greater 
dollar  competition  for  the  limited  quantity  of  goods,  but  rather 
using  more  dollars  to  affect  the  transfer  of  more  goods.  Easy 
and  abundant  credit  may  thus  affect  either  the  level  of  prices 
or  the  volume  of  production  or  both.  Undoubtedly  the  situa- 
tion in  which  prices  and  production  are  both  affected  outnum- 
ber the  cases  in  which  abundant  credit  works  upon  the  one  alone. 
But  as  to  which  is  most  influenced  an  a  priori  answer  is  not 
possible.   It  all  depends  on  the  industrial  situation. 

It  is  unnecessary  to  present  evidence  regarding  the 
nature  of  the  industrial  situation  In  the  period  following 
the  spring  of  19 19.  It  was  a  boom  period  of  the  most  pro- 
nounced character.  Little  good  unemployed  labor  was  to 
be  had,  goods  and  materials  could  be  accjuired  only  by 
bidding  against  competitors  who  were  also  short  in  sup- 

»  See  supra,  pp.  281,  282. 

'  Cf.  1 1.  L.  Reed,  "A  Stabilized  Dollar,"  Atncrican  Economic  Rcvieiv,  March, 
1921,  pp.  91-93. 


310  FEDERAL  RESERVE  POLICY 

plies,  extra  production  could  be  had  only  by  expensive 
enlargements  of  buildings  and  changes  in  machinery. 
Production  could  not  be  speeded  up  so  rapidly  as  credits 
were  increasing.  Speculation,  and  not  social  production, 
absorbed  a  large  portion  of  the  volume  of  bank  credit,  and 
speculation  tended  to  accelerate  the  rapidity  of  price 
advance.  This  was  a  situation  in  which  bank  credit 
played  its  part  in  increasing  the  buying  competition  and 
in  diffusing  throughout  the  business  community  the  buy- 
ing power  in  terms  of  dollars,  on  the  basis  of  which  prices 
were  fixed. 

Simple  as  is  this  principle,  it  is  extremely  difficult  to 
secure  assent  to  it  by  the  general  public.  No  matter  what 
the  industrial  situation,  restrictions  of  credit  grants  are 
always  unpopular.  It  is  always  asserted  that  the  banks 
are  handicapping  productive  enterprise.  It  is  not  under- 
stood that  when  the  productive  engine  is  running  at  full 
speed  more  fuel  will  not  aid  it.  It  is  not  clear  that  credit 
granted  to  this  enterprise  in  a  boom  period  may  not  add 
to  the  total  volume  of  production.  It  is  forgotten  that  too 
great  activity  soon  brings  the  inevitable  reaction  by  en- 
couraging unsound  enterprise.  Money  is  confused  with 
wealth,  and  the  public's  first  reaction  is  always  to  side 
with  the  proponents  of  easy  money. 

Expressive  of  the  popular  point  of  view  the  following 
quotation  might  be  made  from  a  letter  of  a  New  Jersey , 
banker,  E.  C.  Stokes,  written  in  the  summer  of  1920,  to 
Senator  Owen,  commending  the  latter  on  his  protest  at  the 
Board's  belated  policy  in  raising  its  discount  rates:  ^ 

Increased  credit  is  not  the  cause  of  high  prices.  Increased 
credit  is  the  result  of  high  prices  and  is  necessary  because 
prices  are  high.  If  the  industries  and  business  of  the  land  could 
be  assured  of  more  and  cheaper  credit,  production  would  be 

'  See  Commercial  and  Fitiancial  Chronicle,  June  5,  1920,  pp.  2344-45. 


DEVELOPMENT,  NOV.  12,  1918,  TO  MAY,  1920    311 

encouraged,  and  with  an  increase  of  production  prices  would 
fall.  With  assurance  of  the  proper  amount  of  credit  at  reason- 
able rates,  intensive  production  would  follow  and  prices  would 
be  cheaper,  even  without  a  reduction  in  wages.  This  production 
however,  will  never  be  undertaken  by  the  manufacturer  or  even 
by  the  farmer  if  he  thinks  his  loans  are  going  to  be  called  or 
curtailed  and  he  himself  forced  into  bankruptcy  because  of 
inability  to  carry  his  enterprise  to  completion. 


There  then  follow  illustrations  of  the  very  many  projects 
which  it  would  be  desirable  to  encourage.  Not  a  sentence 
in  the  entire  letter  displayed  an  inkling  of  an  understand- 
ing of  where  the  labor  and  materials  for  these  vast  new 
projects  could  be  found.  There  was  no  recognition  of  the 
fact  that  unduly  rapid  credit  grants  at  one  period  cannot 
accelerate  continuously  the  speed  of  the  industrial 
machine.  All  that  was  understood  was  that  economic 
activity  increases  in  the  early  periods  of  cheap  and  abun- 
dant credit.  But  price  adjustment  to  new  and  higher 
levels  makes  the  advantage  of  easy  money  only  temporary. 
Only  continued  increases  in  bank  advances  enable  the 
boom  to  go  on.  There  has  to  be  a  stop  sometime.  It  is 
desirable  that  the  brake  be  put  on  before  the  situation  has 
become  ripe  for  a  violent  reaction.  The  industrial  situa- 
tion must  be  contemplated  from  a  long-  as  well  as  from  a 
short-time  point  of  view. 

It  must  be  admitted,  however,  that  such  demands  for 
unlimited  credits  as  those  just  quoted  from  the  letter  of 
Mr.  Stokes  are  the  natural  fruit  of  the  price  theory,  for- 
mulated by  the  Governor  of  the  Federal  Reserv^e  Board, 
that  prices  determine  the  volume  of  advances  the  banks 
must  make. 

But  this  was  not  all.  Reserve  banks  deal  mainly 
with  member  banks,  and  there  was  much  doubt  as  to  the 
effect  of  rediscount  rate  increases  upon  the  operations  of 


312  FEDERAL  RESERVE  POLICY 

the  latter.  The  spread  between  the  prevailing  commercial 
rate  and  the  reserve  rate  appeared  to  be  so  great  as  to 
make  rcdiscounting  profitable  despite  moderate  redis- 
count rate  increases.  These  rate  increases  could  only  be 
moderate  because  of  the  Treasury's  low-interest-bearing 
flotations.  It  is  true  that  a  higher  rate  could  have  been, 
and  as  a  matter  of  fact  was,  decreed  for  non-war  paper. 
But  this  meant  merely  that  member  banks  ofTered  war 
instead  of  commercial  paper  in  their  rediscount  appli- 
cations. There  was  much  doubt,  moreover,  as  to  how 
efificiently  a  rate  increase  would  work.  There  was  not 
sufhcient  past  experience  to  guide  the  reserve  adminis- 
tration in  the  formation  of  its  discount  policy.  Expression 
was  given  to  this  difficulty  by  the  following  statement  of 
the  October,  1919,   Bulletin:  ^ 

The  extent  to  which  Federal  Reserve  Bank  rates  may  nor- 
mally be  expected  to  be  "effective,"  in  the  sense  in  which  that 
term  is  used  in  Continental  Europe,  still  remains  to  be  deter- 
mined. Our  experience  under  the  Federal  Reserve  system  is  too 
brief  to  enable  definite  conclusions  to  be  drawn  with  reference 
to  this  matter.  It  seems  doubtful,  however,  whether,  for  a  long 
time  to  come  and  taking  the  country  as  a  whole,  there  will  be 
any  such  close  connection  of  Federal  Reserve  Bank  rates  with 
the  volume  of  credit  in  use  as  was  to  be  noted,  for  example,  in 
pre-war  days  in  England,  the  home  of  central  banking.  Our 
nearest  approach  to  an  effective  Federal  Reserve  Bank  rate 
was  reached  in  the  closing  months  of  the  year  19 16. 

This  matter  will  be  discussed  more  completely  in  the 
following  chapter.  But  sufficient  explanation  should  have 
been  offered  regarding  the  hesitation  of  the  Board  to  insist 
upon  higher  rates  in  the  early  part  of  the  industrial  boom 
of  1919. 

The  situation,  however,  soon  became  such  as  to  demand 
restrictive  measures.  The  loss  of  gold  to  foreign  countries, 

'  Page  91 1. 


DEVELOPMENT,  NOV.  12,  1918,  TO  MAY,  1920    313 

together  with  the  great  Increase  of  advances  to  member 
banks  and  note  issues  resulted  in  considerable  worry  re- 
garding the  adequacy  of  the  reserve  ratio/  These  facts 
are  expressed  by  the  following  figures : 


Ratio    of    Cash    Re- 

Total Gold 

Total  Net  Deposits 

serves  to  Net  De- 

Date 

Reserves  of 

AND  Federal  Reserve 

posits  and  Federal 

Reserve  Banks 

Note  Liabilities 

Reserve  Note  Lia- 
bilitifs 

000 

s  Omitted 

19 19 

June  6 

$2,201,804 

$4,225,155 

537 

July  3 

2,128,946 

4-324.351 

50.8 

August  I 

2,088,475 

4,273,001 

50.5 

September  5  .  . 

2,067,052 

4.235.814 

50.4 

October  3 

2,135,282 

4.434.452 

49-7 

November  7  .  . 

2,119.565 

4,677,269 

46.8 

December  26.  .  . 

2,078,432 

4,762,116 

44.8 

Meanwhile  also  the  dates  were  approaching  upon  which 
member  banks  would  no  longer  be  obligated  to  carry  the 
bond  subscriber.  Most  banks  had  agreed  to  make  one- 
year  loans  to  subscribers  for  the  Fourth  Liberty  Loan  and 
six  months'  loans  to  purchasers  of  the  Victory  notes. 
According  to  such  arrangements  these  loans  would  expire 
in  October  and  November.  Although  the  Treasury's  short- 
term  floating  debt  increased  throughout  the  summer  of 
19 19,  it  reached  its  peak  on  August  31,  19 19,  and  it  be- 
came probable  that  the  Treasury's  requirements  would  no 
longer  be  so  controlling  a  factor.  As  stated  in  the  October 
I,  19 19,  Bulletin:^ 

The  disappearance  of  the  Treasury  from  the  long-term  loan 
market  and  the  rapid  reduction  in  its  recjuirements  for  short- 
term  accommodations  foreshadows  the  approach  of  the  time 
when  the  financial  operations  of  the  Government  will  cease  to 
be  the  important  factor  in  shaping  Reserve  Bank  policies  which 
tliey  have  been,  and  Federal  Reserve  Bank  rates  once  more 

'  F"roni  January  I,  1919,  to  November  10,  1919  (the  approximate  date  of  the 
rate  increases),  the  excess  of  gold  exjxjrts  over  gold  imporu  was  ;^226,o89,ooo. 
*  Page  910. 


314  FEDERAL  RESERVE  POLICY 

will  be  fixed  solely  "with  a  view  of  accommodating  commerce 

and  business." 

By  the  fall  of  1919,  moreover,  it  was  becoming  clear  that 
new  creations  of  currency  and  credits  were  no  longer  exert- 
ing a  stimulating  effect  upon  the  country's  productive 
activities.  Much  worry  was  occasioned  also  because  of  the 
undesirable  quality  of  paper  in  member  banks'  portfolios. 
In  particular,  the  percentage  of  renewals  was  far  too  large. 
What  theory  had  predicted  confidently  at  an  earlier  date 
was  now  being  exemplified  by  results.  The  country's  pro- 
ductive mechanism  could  not  accommodate  too  big  a  load. 
In  the  early  part  of  November,  accordingly,  rates  were 
increased  slightly  at  all  reserve  banks  as  a  means  of 
indicating  the  determination  to  raise  rates  still  higher  if 
the  reserve  ratio  fell  further.  On  December  11,  after 
the  autumnal  demand  for  funds  had  subsided,  another 
slight  rate  increase  was  sanctioned  by  the  Board. 

The  reluctance  of  the  reserve  administration  to  adopt 
these  measures  is  evidenced  by  the  fact  that  the  increase 
was  preceded  by  many  warnings.  For  instance,  on  June 
10,  1919,  the  Board  made  public  the  following  letter  which 
had  been  sent  out  to  all  Federal  Reserve  agents:  ^ 

The  Federal  Reserve  Board  is  concerned  over  the  existing 
tendency  toward  excessive  speculation,  and  while  ordinarily 
this  could  be  corrected  by  an  advance  in  discount  rates  at  the 
Federal  Reserve  Banks,  it  is  not  practicable  to  apply  this  check 
because  of  Government  financing.  By  far  the  larger  part  of  the 
invested  assets  of  Federal  Reserve  banks  consists  of  paper 
secured  by  Government  obligations,  and  the  Board  is  anxious 
to  get  some  information  on  which  it  can  form  an  estimate  as  to 
the  extent  of  member  bank  borrowings  on  Government  collat- 
eral made  for  purposes  other  than  for  carr>'ing  customers  who 
have  purchased  Liberty  bonds  on  account,  or  other  than  for 
purely  commercial  purposes. 

«  Ci.  Bulletin,  December  i,  1919.  P- 1108. 


DEVELOPMENT.^NOV.  12,  1918,  TO  MAY,  1920    315 

The  rate  increases  of  1919  were  continued  in  the  earty 
months  of  1920.  In  January,  after  the  Treasury  had 
raised  the  rate  on  short-term  certificates  to  4^  per  cent, 
the  Board  approved  a  similar  increase  on  paper  secured  by 
these  certificates. 

Toward  the  end  of  January,  however,  the  rate  on  paper  se- 
cured by  Liberty  bonds  and  Victory  notes  was  advanced  to 
5^2  per  cent  and  the  rates  on  all  classes  of  commercial  paper, 
including  trade  acceptances  and  agricultural  and  live-stock 
paper,  to  6  per  cent.* 

Except  in  the  financial  centers  of  the  country  these 
increased  rates  had  Httle  real  effect  in  checking  the  con- 
tinuous expansion  of  credits.  By  the  end  of  April,  1920, 
the  total  earning  assets  of  reserve  banks  were  considerably 
larger  than  in  December,  19 19.  But  it  had  become  evident 
that  the  rate  of  credit  and  currency  increase  was  falling 
and  that  the  speculative  boom  was  collapsing.  With  the 
spring  of  1920,  one  stage  in  the  post-war  business  cycle 
was  drawing  to  a  close, 
*  Report  of  the  Federal  Reserve  Board,  1920,  p.  57. 


CHAPTER  XVI 

FEDERAL  RESERVE  DEVELOPMENT,  MAY,  1920.  TO 

THE  PRESENT  TIME 

THE  PERIOD  OF  BUSINESS  READJUSTMENT 

It  is  no  part  of  the  writer's  purpose  to  measure  statistically 
the  relative  influence  of  the  various  factors  which  cooper- 
ated to  create  the  industrial  reaction  of  1920-21.  Such  a 
task  would  far  exceed  the  limits  of  the  present  chapter.  It 
will  sufhce  for  our  plans  to  indicate  the  instability  of  the 
industrial  situation  in  the  spring  of  1920  and  to  state 
briefly  the  causes  of  the  subsequent  depression. 

In  the  opinion  of  many  the  post-war  boom  had  carried 
us  to  a  new  and  permanently  higher  level  of  prices.  A  very 
large  part  of  the  world's  total  gold  supply  had  come  to  the 
United  States,  and  this  gold,  in  large  measure  deposited 
in  the  vaults  of  the  Federal  Reserve  banks,  had  furnished 
the  basis  for  the  creation  of  a  much  larger  volume  of 
deposits  and  note  issues  than  the  country  ever  before  had 
witnessed.  Relatively  to  commodities  the  media  of  ex- 
change had  been  greatly  increased.  The  international 
trade  situation,  moreover,  was  not  such  as  to  indicate  any 
early  redistribution  of  our  gold  among  the  nations  of 
Europe.  Consequently,  a  larger  volume  of  bank  deposit 
and  note  currency  could  be  supported  without  endanger- 
ing in  the  immediate  future  the  maintenance  of  the  gold 
standard.  There  were  no  indications,  furthermore,  that 
our  banking  administration  would  endeavor  to  deflate  for 
the  purpose  of  restoring  the  old  price  level.  All  the  evi- 
dence pointed  toward  the  acceptance  of  the  belief  that 
attempts    to    correct    financial    maladjustments    should 


DEVELOPMENT,  MAY,  1920,  TO  PRESENT      317 

assume  the  form  of  such  devices  as  wage  advances  and 
railway  rate  increases.  The  rises  in  rediscount  rates  of  the 
preceding  period  clearly  had  been  initiated  only  as  a  means 
of  preserving  the  reserve  ratio  and  of  preventing  the  inclu- 
sion in  bank  portfolios  of  too  large  a  quantity  of  unsound 
paper. 

Nevertheless, 'the  memories  of  a  lower  price  level  were 
still  vivid  to  a  large  portion  of  the  people.  It  is  true  there 
held  been  no  indication  of  a  sudden  return  to  the  19 13 
level.  But  any  temporary  decline  in  the  market  would  be 
interpreted  generally  as  the  beginning  of  the  process  of 
reestablishing  "normality"  in  prices.  In  this  situation  a 
voluntary  lowering  of  prices  to  relieve  congestion  in  the 
warehouses  or  on  the  shelves  of  merchants  might  not  have 
the  effect  of  increasing  buying  suddenly.  If  this  viewpoint 
should  be  adopted  generally,  orders  might  be  cancelled  in 
large  volume,  the  demand  for  labor  lessened,  and  the  re- 
duction in  money  wages  restrict  the  ability  of  the  public 
to  purchase  goods.  All  that  was  required  to  set  in  motion 
a  continuously  accelerating  buyers'  strike  was  evidence  of 
temporary  weakness  in  the  market. 

The  unhealthiness  of  the  situation  was  due  also  to  the 
fapidity  of  the  price  advance.  All  the  weaknesses  which 
normally  develop  in  a  period  of  prosperity  had  been  accen- 
tuated by  the  amazing  speed  in  the  upward  movement  of 
the  market.  Commodity  and  security  speculation  had 
been  overdone  grossly;  labor  was  losing  its  discipline;  the 
assumption  of  unwise  ventures  had  been  encouraged  by 
artificial  cheapness  of  money;  bank  reserves  were  falling 
rapidly.  On  the  New  York  Stock  Exchange  the  shares 
traded  in  during  19 19  were  almost  fourfold  as  great  as  in 
19 13,  and  bond  activity  was  multiplied  almost  sevenfold. 
Total  bank  clearings  for  the  Nation  were  approximately 
two  and  a  half  times  as  great  in  19 19  as  in  19 13.    The 


3i8  FEDERAL  RESERVE  POLICY 

Comptroller's  reports  showed  that  net  deposits  of  national 
banks  had  increased  from  7.1  billions  of  dollars  on  October 
21,  1913,  to  12.2  billions  on  September  12,  1919. 

It  is  inevitable  in  such  eras  that  values  and  operations 
become  based  not  solely  upon  confidence  that  former 
growth  will  be  maintained,  but  that  the  rate  of  accelera- 
tion will  be  continued.  Present  speculation  rests  upon 
future  anticipations.  But  by  the  spring  of  1920  it  was 
evident  that,  while  the  limit  of  their  resources  had  not  been 
reached,  banks  were  genuinely  worried  as  to  their  ability 
to  finance  new  projects.  The  maturities  of  paper  were 
growing  and  the  percentage  of  renewals  increasing.  Con- 
siderations of  public  finance  pointed  also  toward  higher 
rates  in  the  near  future.  In  1920  the  Treasury  advanced 
the  rates  on  six  months'  certificates  to  53^  per  cent  and  to 
6  per  cent  for  twelve  months'  maturities.  The  Treasury 
was  no  longer  to  dominate  the  reserve  banks  so  completely 
in  the  formation  of  discount  policies.  The  money  market 
was  no  longer  to  be  kept  so  low  by  artificial  measures.  The 
true  rate  of  interest  was  to  be  permitted  to  emerge.  Coin- 
cidentally  with  the  rise  in  rates  the  member  banks  were 
being  cautioned  against  the  granting  of  unessential  credits. 
Further  credit  expansion  was  possible,  but  the  rate  of  past 
growth  must  fall. 

Had  the  physical  volume  of  production  been  less  large 
in  19 19  and  1920  the  date  of  the  reaction  might  have  been 
postponed.  But  the  volume  of  production,  particularly  in 
the  first  half  of  1920,  was  enormous.  The  Government's 
crop  forecasts  for  1920  were  exceedingly  favorable,  presag- 
ing one  of  the  best  years  on  record.  Mills  and  factories 
were  thought  generally  to  be  working  close  to  maximum 
capacity.  But  railroads  found  themselves  unequal  to  the 
strain  thrown  upon  them.  The  reports  of  the  American 
Railroad  Association  disclosed  a  net  shortage  of  cars  three 


DEVELOPMENT,  MAY,  1920,  TO  PRESENT      319 

of  the  last  four  months  of  19 19  and  for  every  month  of  the 
first  half-year  of  1920.  Shipments  which  might  have  been 
dispatched  on  advantageous  terms  were  delayed  until  an 
enormous  quantity  of  goods  accumulated  in  the  centers  of 
production.  It  required  not  much  of  a  shock  to  induce  a 
general  order  of  price  cutting  in  order  to  move  goods. 

It  had  been  apparent  for  some  time  that  the  inter- 
national trade  situation  was  growing  more  and  more  un- 
healthy.   The  balance  of  trade  for  19 19  was  over  four 
billions  of  dollars  in  our  favor,  exceeding  all  past  records. 
But  in  each  of  the  first  four  months  in  1920  the  balance  in 
our  favor  was  much  less  than  that  for  19 19.    In  several 
markets  1920  was  to  witness  a  sharp  price  break.  After  the 
early  collapse  of  the  silk  market  in  Japan,  there  were  rapid 
declines  in  the  prices  of  sugar,  coffee,  and  other  products 
of   Cuba  and   Latin-American   countries.     The   Federal 
Reserve    Board's    international    wholesale    price    index 
showed  a  price  decline'  in  April  for  Japan,  and  a  May  de- 
cline for  the  United  Kingdom,  France,  Italy,  and  Japan. 
In  June,  1920,  the  Bureau  of  Labor  Statistics'  index  num- 
ber for  wholesale  prices  of  all  commodities  in  the  United 
States  was  to  show  the  first  recession  experienced  since  the 
early  part  of  19 19.   The  accumulation  of  goods  created 
by  the  inability  of  the  railroads  to  furnish  sufficient  cars 
and  the  crash  in  foreign  markets  may  have  been  the  imme- 
diate factors  causing  the  first  severe  shock  to  business  con- 
fidence.  Once  this  check  had  been  felt,  it  was  impossible 
I  to  prevent  the  manifestation  of  all  the  weaknesses  in  the 
industrial  system  which  have  been  developing  gradually 
in  the  preceding  boom  period.   The  buyers'  strike  became 
soon,  not  a  matter  of  volition,  but  of  downright  necessity. 
The  reduction  in  money  incomes  created  less  demand  for 
labor's  services. 
'  See  Report  of  the  Federal  Reserve  Board  for  1920,  p.  7. 


320 


FEDERAL  RESERVE  POLICY 


A  large  part  of  the  Federal  Reserve  administration's 
policy  during  the  crisis  may  be  told  statistically.  The 
following  figures  depict  the  situation  regarding  changes  in 
the  reserve  ratio,  note  issues,  member  banks'  reserve 
account,  total  earning  assets,  and  rates  of  discount  on 
ninety-day  paper. 


Date 


1920 
May  7  . , 
June  4  , 
Julys.. 
Aug.  6  . 
Sept.  3. 
Oct.  I . . 
Nov.  5  . 
Dec.  3  . 


192 1 
Jan. 7... 
Feb.  4. . . 
March  4. 
April  I . . 
May  4  , . 
June  I  . . 
July  6... 
Aug.  3  . . 
Sept.  7. . 
Oct.  5... 
Nov.  2  . . 
Dec.  28  . 


Total 
Earning 
Assets 


Federal 
Reserve 
Notes  in 
Circula- 
tion 


In  billions  of  dollars 


3.21 
3-27 
3-27 
3-18 
3-36 
330 
342 
3-33 


3.13 
2.88 
2.78 
2.61 
2.42 
2.26 
2.09 
1.90 

1.79 
1.66 

1-54 
1-53 


3-09 
3.12 
3.16 
3-14 
324 
3-30 
3-35 
3-31 


3-27 
3-07 
3-04 
2.90 
2.82 

2.75 
2.67 

2.53 
2.51 

2.48 
2.40 
2.44 


Discount 

Rate  on 

Member 

Banks' 

Reserve 

Account 

Cash 

Reserve 

Ratio 

90-Day 
Paper  in 

Effect 
First  Day 

OF  THE 

Month  > 

Discount 

Rate  on 

90-Day 

Paper 

Secured  by 

Liberty 

Bond  and 

Victory 

Notes  thb 

First  Day 

OF  the 

MONTHt 


In  percentage 


1.79 
1.74 
1.70 
1.67 
1.67 
1.65 
1.65 
I.61 
1.63 
I.61 
1.65 
1.66 


42.7% 

6% 

42.5 

6.25 

42.8 

6.3 

44.0 

6.3 

42.5 

6.3 

43-7 

6.3 

43-0 

6.4 

44.1 

6.4 

46.4 

6.4 

49-3 

6.4 

50.8 

6.5 

52.4 

6.5 

55-3 

6.4 

57-4 

6.19 

60.0 

6.08 

637 

5-87 

66.2 

5-79 

69.0 

5-75 

71.0 

5.66 

71. 1 

5-04 

5-6% 

5-7 

576 

577 

577 

5-81 

5-8i 

5-81 


5-8i 
5-81 
5-95 
5-95 
5-95 
5-95 
5-95 
5.83 
574 
570 
5.66 
5-04 


•  Average  for  the  twelve  Districts. 


These  facts  show  that  there  was  no  contraction  of  cur- 


DEVELOPMENT,  MAY,  1920,  TO  PRESENT      321 

rency  or  credits  enforced  by  Federal  Reserve  authority 
during  the  depression.  The  combined  Federal  Reserve 
note  circulation  and  member  banks'  reserve  account  at 
the  close  of  1920  exceeded  that  of  the  spring  of  the  year.  It 
should  be  kept  in  mind  that  these  advances  were  main- 
tained in  volume  despite  the  drop  in  prices.  Since  lower 
prices  lessen  the  need  for  credits,  the  growth  in  reserve 
bank  advances  was  in  reality  much  larger  than  the  figures 
indicate.  The  wholesale  price  index  of  the  Bureau  of  Labor 
Statistics,  which  was  272  in  May,  1920,  had  fallen  to  189 
in  December  of  the  same  year.  So  willing  were  the  reserve 
authorities  to  employ  their  resources  for  the  legitimate 
requirements  of  member  banks  that  it  was  not  until  after 
the  beginning  of  the  new  year  that  the  reserve  ratio  began 
to  move  to  a  point  commanding  confidence.  Discount 
rates  increased  until  the  spring  of  1921,  but  they  were 
never  unusually  high  relatively  to  market  rates.  As  a 
matter  of  fact  they  followed  rather  than  preceded  the 
movement  of  money  rates  in  the  financial  centers.  Until 
the  summer  of  192 1  rates  on  four  to  six  months'  prime 
commercial  paper  were  close  to  eight  per  cent  in  the  New 
York  market. 

Recovery  from  the  crisis  was  slow  and  uncertain.  Bond 
and  stock  prices  began  to  move  upward  sharply  in  the 
early  summer  of  192 1.  But  security  price  movements 
precede  usually  the  revival  of  business  confidence.  It  was 
not  until  the  close  of  192 1  that  the  volume  of  new  securi- 
ties issued  became  such  as  to  indicate  any  general  return 
of  confidence.  Nevertheless,  at  the  close  of  the  year  statis- 
tics of  failures  portrayed  greater  mortality  than  at  any 
preceding  date  of  the  crisis. 

The  public  was  somewhat  slow  to  perceive  the  extreme 
severity  of  the  depression.  Mad  there  been  no  Federal 
Reserve  system  to  prevent  credit  contraction,  a  financial 


322  FEDERAL  RESERVE  POLICY 

panic  of  unexampled  dimensions  might  easily  have 
occurred.  What  the  reserve  system  has  done  has  been  to 
draw  out  the  period  during  which  liquidation  took  place. 
But  so  far-reaching  were  the  maladjustments  which  had 
developed  in  the  preceding  boom  period  that  no  sudden 
revival  of  confidence  was  possible.  Too  many  prices  got 
out  of  line  with  each  other.  Relatively  to  other  prices, 
agricultural  commodities  fell  too  far.  As  a  consequence 
the  agricultural  demand  for  manufactured  products  con- 
tinues low.  Unless,  furthermore,  adequate  machinery  is 
developed  for  supplying  Europe  with  production  goods  for 
restoration  purposes,  we  cannot  count  on  the  foreign 
demand.  Building,  however,  is  rapidly  developing  into 
the  dimensions  of  a  boom,  and  in  this  lies  the  germ  of 
speedy  resumption  of  industrial  activity. 

With  the  clearing  of  the  industrial  situation  it  is  espe- 
cially desirable  that  Federal  Reserve  policy  for  the  future 
be  formulated  more  definitely.  In  all  the  eight  years  of 
Federal  Reserve  operation  there  has  not  been  a  period 
when  the  administration  was  free  to  make  a  comprehen- 
sive statement  of  the  relation  of  the  reserve  banks  to  other 
parts  of  the  financial  mechanism.  Until  19 17  the  problem 
was  that  of  acquainting  member  banks  with  the  reserve 
banks'  facilities  and  of  getting  into  the  market  at  a  time 
when  member  banks'  reserves  were  high.  From  1917  to 
the  armistice  the  requirements  of  war  or  of  war  prepara- 
tion were  dominant  considerations.  In  the  post-war  ex- 
pansion period  the  Treasury's  needs  were  such  as  to  cause 
purely  banking  requirements  to  be  subordinated.  In  the 
period  of  depression  the  inevitable  charges  of  undue  sever- 
ity made  the  situation  inopportune  for  any  clear  state- 
ment of  future  discount  policy.  But  in  the  coming  period 
of  industrial  revival  it  is  important  that  the  essentials  of 
rediscount  control  be  developed.    If  this  be  not  done, 


DEVELOPMENT,  MAY,  1920,  TO  PRESENT      323 

industrial  activity  again  may  attain  unhealthy  dimensions 
thus  breeding  the  forces  of  another  reaction.  The  late 
depression  has  shown  that,  while  the  reserve  system  may 
serve  to  prevent  sudden  liquidation  and  thus  to  lessen  the 
acuteness  of  the  shock,  it  cannot  prevent  unhealthy 
tendencies  from  asserting  themselves  in  the  form  of 
destroyed  business  confidence. 

At  the  present  time  the  surplus  reserves  of  the  reserve 
banks  are  enormous.  December  28,  1921,  the  total  re- 
serves of  the  reserve  banks  were  2992.2  millions  of  dollars. 
This  would  form  a  forty  per  cent  reserve  for  7480  millions 
of  note  issues  and  deposit  credits  granted  to  member 
banks.  Assuming  member  banks  require  a  fifteen  per  cent 
counter  money  and  legal  reserve  combined,  this  7480  mil- 
lions would  enable  them  to  advance  49,866  millions  to  the 
business  public.  Since  the  total  net  deposits  of  national 
banks  on  the  Comptroller's  report  for  September  6,  192 1, 
was  10.8  billions  of  dollars,  an  approximate  fourfold  expan- 
sion in  national  member  banks'  advances  is  possible.  Here 
lie  opportunities  for  inflation  never  before  possessed  in  like 
measure  by  any  banking  system.  If  any  large  part  of  this 
new  credit  supply  is  utilized  suddenly,  the  price  level  must 
react  correspondingly.  It  is  not  possible  that  our  physical 
volume  of  production  be  increased  in  any  such  meas- 
ure. Too  rapid  credit  expansion  must  mean  price  inflation. 
It,  therefore,  is  more  essential  now  than  ever  before 
that  definite  principles  of  credit  control  be  formulated. 
Day-to-day  considerations  cannot  be  permitted  to  gov- 
ern unless  the  reserve  banks  are  to  become  mere  engines 
of  inflation. 

Until  business  confidence  is  restored  there  is  no  danger 
of  unduly  rapid  creations  of  currency  or  credits.  New 
issues  would  become  redundant.  But  in  the  next  era  of 
business  revival  it  will  be  necessary  to  know  when  the 


324  FEDERAL  RESERVE  POLICY 

endeavor  should  be  made  by  reserve  banks  to  restrict 
credit  increases.  Let  us  consider  accordingly  the  wis(J(.>m 
and  practicability  of  the  following  bases  of  credit  control : 

(a)  Regard  should  be  had  primarily  for  the  reserve 
ratios  of  reserve  banks.  In  other  words,  reserve  banks 
should  take  into  account  the  same  sort  of  considerations 
which  guide  the  loan  policies  of  member  banks.  They 
should  concern  themselves  primarily  with  their  ability  to 
meet  their  obligations. 

(b)  Credit  advances  of  reserve  banks  should  be  regu- 
lated in  such  a  manner  as  to  maintain  the  price  level  as 
stable  as  possible. 

(c)  Credit  advances  should  be  regulated  In  such  a  man- 
ner as  to  maintain  the  productive  activities  of  the  Nation 
as  great  as  possible.  Regard  should  be  had,  however,  for 
long  rather  than  for  short-time  considerations. 

(d)  Since  certain  excesses,  such  as  impaired  liquidity, 
appear  whenever  industrial  activity  is  fanned  by  excessive 
credit  grants,  restriction  should  be  begun  whenever  these 
evils  become  more  than  ordinarily  prominent. 

Let  us  consider  these  possibilities  in  turn. 

There  appears  to  be  much  to  ofTer  for  a  policy  of  utiliz- 
ing the  reserve  ratio  as  a  guide  for  rediscount  policy.  In 
Sprague's  words:  ^ 

It  is  definite  and  obvious.  Public  opinion  may  be  expected 
to  support  the  always  unwelcome  policy  of  credit  restraint 
when  that  policy  is  enforced  by  a  depleted  reserve.  It  is  un- 
happily very  doubtful  whether  the  public  would  have  been 
reconciled  to  the  advance  in  rates  made  last  spring  [1920]  if 
the  reserve  banks  had  had,  let  us  say,  a  reserve  ratio  of  55 
per  cent,  and  yet,  all  other  things  being  the  same,  an  advance 
in  rates  would  have  been  no  less  desirable. 

'  Cf.O.  M.  W.  Sprague,  "The  Discount  Policy  of  the  Federal  Reserve  Banks, ' 
American  Economic  Review,  Marcli,  1921,  pp.  27,  26. 


DEVELOPMENT,  MAY,  1920,  TO  PRESENT      325 
Further: 

There  is  no  substitute  for  the  reserve  ratio  which  possesses  its 
pecuUar  virtues  of  simpUcity  and  deliniteness. 

It  is  extremely  unfortunate,  therefore,  that  the  situation 
frequently  may  develop  to  necessitate  credit  restriction 
even  at  a  time  when  reserves  are  increasing.  In  a  season 
of  very  active  trade,  payment  of  foreign  balances  might 
compel  the  shipment  of  gold  to  this  country.  In  that 
situation  our  bank  reserves  would  Increase,  yet  the  possi- 
bilities of  too  rapid  expansion  might  then  exist.  The  quan- 
tity of  gold  in  the  reserves  is  a  product  of  more  or  less  for- 
tuitous circumstance  and  bears  no  necessary  relation  to 
the  credit  requirements  of  business. 

There  is  also  much  to  say  for  making  price  stability  the 
test.  The  injustices  of  a  rapidly  changing  price  level  are 
now  recognized  fully.  Since  bank  credit  is  our  most  Impor- 
tant medium  of  exchange,  its  volume  should  be  regulated 
in  such  a  way  as  to  ensure  a  fair  degree  of  price-stability 
over  a  course  of  time.  It  is  also  true  that  a  chief  evil  created 
in  a  boom  period  is  the  throwing  out  of  adjustment  of 
various  prices.  The  greater  the  rise  in  the  general  level,  the 
greater  the  probability  that  their  normal  relationship  will 
be  disturbed.  To  maintain  the  level  of  prices  stable, 
therefore,  might  accomplish  much  in  the  way  of  eliminat- 
ing periodic  disturbances  In  business. 

It  is  doubtful,  however,  whether  public  opinion  would 
ever  sanction  the  use  of  such  a  guide.  As  Intllcated  pre- 
viously, the  people  of  this  country  lean  innately  toward 
the  side  of  easy  money.  Particularly  true  is  this  of  seasons 
of  activity.  The  matter  of  legal  authority  for  such  a  test 
is  also  doubtful.  Mr.  A.  C.  Miller,  of  the  Federal  Reserve 
Board,  has  stated:' 

•  "Federal  Reserve  Policy,"  American  Economic  Review,  June,  1921,  p.  193. 


326  FEDERAL  RESERVE  POLICY 

There  is  now  no  warrant  in  the  statute  under  which  the  fcrlcral 
reserve  banks  are  organized  for  undertaking  to  regulate  their 
credit  operations  on  any  such  basis.  The  economic  logic  of  the 
Federal  Reserve  act  is  clearly  predicated  upon  the  theory  that 
the  federal  reserve  banks  shall  be  operated  with  regard  to  re- 
serve ratios,  and  "rates  be  fixed  with  a  view  of  accommodating 
commerce  and  business."  It  would  imply  a  very  latitudinarian 
construction  of  the  term  "accommodating  commerce  and 
business"  for  the  Federal  Reserve  Board  and  the  federal 
reserve  banks  to  adopt  the  "observed  effects  of  credit  on  prices" 
as  their  rule  of  action  in  the  future.  There  is  not,  however,  the 
slightest  reason  for  supposing  that  such  a  procedure  on  the  part 
of  the  federal  reserve  banks  would  be  viewed  with  public 
approval.  Quite  the  contrary.  Public  sentiment  in  the  United 
States  is,  and  always  has  been,  highly  sensitive  in  matters  of 
credit  control,  and  precisely,  among  other  reasons,  because 
of  the  bearing  that  such  control  has,  or  is  believed  to  have  upon 
the  movement  of  prices. 

Mr.  Miller's  efforts  accordingly  are  designed  to  alter  the 
reserve  machinery  in  such  a  way  as  to  make  it  more  safe 
to  depend  upon  the  use  of  reserve  ratios  as  a  guide. 

Mr.  R.  C.  Lefifingwell's  vigorous  statement  on  this 
matter  is  as  follows :  ^ 

I  share  Dr.  Miller's  objection  to  Professor  Sprague's  sugges- 
tion that  federal  reserve  rates  should  be  determined  by  price 
movements.  There  is  no  man,  or  group  of  men,  to  whom  the 
American  people  will,  or  should,  accord  the  right  to  determine 
whether  they  shall  be  prosperous  or  miserable,  whether  thay 
shall  have  high  prices  or  low  prices,  whether  they  shall  have 
good  times  or  bad  times.  The  day  Professor  Sprague's  sugges- 
tion is  adopted  by  the  Federal  Reserve  Board  marks  the  end  of 
the  federal  reserve  system.  It  would  be  absurd  for  the  Federal 
Reserve  Board  to  ignore  price  movements  as  symptoms  of  the 
general  situation,  but  it  cannot  base  its  discount  policy  upon 
them. 

Both  Miller  and  LefiEingwell  admit  that  the  reserv-e 

'  "The  Discount  Policy  of  the  Federal  Reserve  Banks,"  American  Economic 
Review  March,  192 1,  p.  35. 


DEVELOPMENT,  MAY,  1920,  TO  PRESENT      12-] 

ratio  alone  cannot  be  an  adequate  guide.  But  in  order  to 
enable  it  to  be  utilized  with  effectiveness,  they  make  cer- 
tain proposals  designed  to  remove  the  dangers  connected 
with  its  use.   Leffingwell  suggests'  that 

If  the  reserve  gets  big  enough  to  be  embarrassing,  the  best  cure 
for  the  situation  which  will  then  arise  is  to  pay  out  gold  and 
gold  certificates,  and  restore  them  to  circulation. 

This  would  have  the  effect  of  reducing  the  reserve  ratio  to 
a  more  manageable  point.  In  an  opposite  situation,  one 
in  which  the  reserve  ratio  is  low,  gold  could  be  retained 
when  paid  in  by  member  banks  and  Federal  Reserve 
notes  issued  to  meet  the  general  currency  requirements. 

Miller's  suggestion  is  much  more  involved.  He  desires' 
the  Federal  Reserve  notes  to  become  more  similar  to  the 
issues  of  the  Bank  of  England.  If  a  larger  gold  reserve 
could  be  allocated  for  note  issues,  the  reserve  ratio  for 
deposits  could  be  made  such  as  to  render  it  safer  to  depend 
upon  it.  Calls  by  the  public  for  more  credits,  calls  which 
arise  in  time  of  rapid  expansion,  would  reduce  rapidly  the 
reserve  for  deposits  in  such  a  way  possibly  as  to  justify 
efforts  to  restrict  further  advances.  In  this  way  the  reserve 
ratio  could  be  made  a  more  workable  guide. 

Dr.  Miller's  suggestion  is  so  important  as  to  justify, 
perhaps,  a  somewhat  extended  quotation  from  his  re- 
marks. Speaking  first  of  the  administrative  changes  that 
need  to  be  made  he  states: 

The  main  change  in  the  published  weekly  statement  of  the 
federal  reserve  banks  that  would  be  necessary  would  be  to 
report  the  specific  note  reserve,  held  by  the  Federal  Reserve 
Agent,  and  the  specific  deposit  reserve  held  by  the  bank.  The 
existing  practice  of  stating  the  reserve  position  theoretically 
in  the  form  of  a  ratio  derived  from  a  comparison  of  total  re- 

•  "The  Discount  Policy  of  the  Federal  Reserve  Banks,"  American  Eco- 
ttamic  Review,  March,  192 1,  p.  36. 
'Oi^.cit. 


328  FEDERAL  RESERVE  POLICY 

serves  with  combined  note  and  deposit  liabilities  should  be  dis- 
continued, or,  if  continued,  be  given  merely  for  purposes  of 
theoretical  comparison,  by  the  federal  reserve  system,  and  a 
form  of  statement  should  be  set  up  which  would  show  the  re- 
serves actually  held  against  deposits  and  notes  respectively  and 
separately,  as  the  law  contemplates. 

The  existing  gold  holding  of  the  reserve  banks  should  be  re- 
apportioned between  the  deposit  reserve  and  the  note  reserve. 
To  the  deposit  reserve  might  be  allocated  an  amount  of  reserve 
money  equivalent,  say,  to  45  per  cent  of  their  deposit  liabilities 
as  of  the  date  when  the  new  form  of  accounting  would  become 
effective.  To  the  note  reserve  should  be  allocated  all  the  remain- 
ing reserve,  and,  as  the  law  requires,  be  in  the  form  of  gold. 

The  reserve  thus  allocated  to  the  deposit  reserve  should  be 
regarded  as  the  working  reserve  of  the  banking  or  discount 
department  of  the  federal  reserve  bank.  The  banks  should  be 
expected  to  conduct  their  discount  operations  on  the  basis  of 
this  reserve.  Until  conditions  justified,  the  amount  of  this 
reserve  should  not  be  changed.  Fresh  accessions  of  gold  re- 
ceived by  the  banking  department  should  be  transferred  to  the 
note  reserve  by  way  of  substitution  for  other  collateral  held 
by  the  Federal  Reserve  Agent,  or  in  exchange  for  federal 
reserve  notes.  Withdrawals  of  gold  from  federal  reserve  banks 
for  foreign  shipment  should,  for  the  present  at  least,  be  taken 
out  of  the  note  reserve  by  the  presentation  of  federal  reserve 
notes  for  redemption  in  gold  or  by  the  substitution  of  com- 
mercial collateral  for  gold  in  the  security  held  by  the  Federal 
Reserve  Agent.  The  deposit  reserve  held  by  the  banking 
department  would  thus  be  fairly  constant  in  amount;  the  note 
reserve,  on  the  other  hand,  would  be  variable  in  amount, 
fluctuating  mainly  in  accordance  with  changes  in  the  inter- 
national flow  of  gold,  increasing  when  an  influx  was  in  progress 
and  decreasing  when  an  outflow  was  in  process. 

While  the  deposit  reserve  under  the  arrangement  proposed 
above  would  be  constant,  the  deposit  reserve  ratio  would  not  be 
constant  but  would  fluctuate.  Any  expansion  of  the  loan 
account  of  the  federal  reser\'e  banks  would  quickly  reflect  itself 
in  the  diminution  of  the  reserve  ratio  below  45  per  cent;  any 
diminution  of  their  loan  account  would  quickly  reflect  jtself  in 
an  increase  of  tlie  reserve  ratio  above  45  per  cent.    In  brief, 


DEVELOPMENT,  MAY,  1920,  TO  PRESENT      329 

fluctuations  in  the  reserve  ratio  would  reflect  quickly  and  accu- 
rately changes  in  the  volume  of  the  reserve  banks'  discounts. 

From  time  to  time  the  situation  of  the  reserve  banks  as  a 
whole,  and  of  the  several  reserve  banks  individually,  should  be 
reviewed  in  the  light  of  current  credit  conditions  and  needs  in 
order  to  determine  whether  any  reapportionment  of  reserves 
should  be  made;  whether,  e.  g.,  any  given  bank  should  enlarge 
its  deposit  reserve  at  the  expense  of  its  note  reserve.  The 
modus  operandi  for  effecting  such  enlargement  would  be  for 
the  bank  in  question  to  substitute  commercial  paper  for  gold 
as  for  collateral  security  pledged  with  the  Reserve  Agent  for 
notes  issued  to  the  bank,  the  gold  thus  released  being  covered 
into  the  deposit  reserve.  So  far  as  the  bank's  reserve  position 
was  concerned,  this  would  be  tantamount  to  the  transfer  of  a 
certain  amount  of  gold  from  the  note  reserve  to  the  deposit 
reserve  in  order  to  give  the  bank  an  enlarged  basis  of  lending. 

Under  this  arrangement  the  reserve  ratio  would  decline 
rapidly  In  an  era  of  credit  expansion.  "It  would  l)e  a 
faithful  indicator  of  what  was  going  on."  It  could  be 
relied  upon  much  more  confidently  than  at  present.  At 
the  same  time,  the  public  could  anticipate  with  much  more 
certainty  future  credit  policy. 

Adequate  preparation,  furthermore,  would  have  been 
made  for  future  outflows  of  gold  to  foreign  countries.  It 
seems  impossible  that  the  world's  gold  can  continue  per- 
manently to  be  apportioned  as  inequitably  as  at  the  pres- 
ent time.  Future  withdrawals  will  likely  be  of  enormous 
volume.  Under  Dr.  Miller's  plan  the  gold  for  these  with- 
drawals would  be  conserved  in  the  note  reserve  instead 
of  having  become  demobilized  by  forming  the  necessary 
reserve  for  enlarged  credit  advances.  This  matter  of  mak- 
ing provision  for  future  gold  withdrawals,  furtherniore, 
might  be  accepted  by  the  public  as  justification  for  this 
proposed  change  much  more  readily  than  the  desire  to 
protect  the  system  against  future  price  inflation. 

Although  these  suggestions  represent  merely  an  attempt 


330  FEDERAL  RESERVE  POLICY 

to  remodel  the  Federal  Reserve  system  more  closely  on  the 
pattern  of  the  Bank  of  England,  they  appear  to  the  writer 
to  deserve  credit  as  a  constructive  proposal  of  great  merit. 
It  is  particularly  fortunate  that  they  were  fc«TTiulated  by  a 
member  of  the  Board. 

But  valuable  as  these  suggestions  may  be,  their  adop- 
tion would  not  provide  a  complete  solution.  There  would 
still  remain  the  question  as  to  just  how  great  pressure 
should  be  exerted  at  any  one  time  to  keep  the  credit  situa- 
tion under  control.  How  close  to  the  legal  minimum  could 
the  deposit  reserve  be  permitted  to  sink  without  endan- 
gering its  eventual  sufficiency?  And  what  would  be  the 
reply  of  the  reserve  administration  if  it  were  argued  that 
its  policy  had  been  to  the  economic  detriment  of  the 
country  and  that  the  gold  earmarked  as  the  deposit 
reserve  had  been  made  either  too  large  or  too  small.  In  the 
final  analysis  the  test  of  economic  results  must  be  applied 
to  the  reserve  administration's  acts.  Making  the  reserve 
ratio  a  more  accurate  indicator  will  not  accomplish  every- 
thing. 

The  writer  agrees  with  Miller  and  Lefhngwell  that  there 
is  no  authority  in  the  act  for  making  price  stability  the  test 
of  discount  policy.  Neither  would  it  comprise  per  se  an 
infallible  test  from  the  standpoint  of  economic  theory. 
High  prices  may  be  due  to  other  causes  than  excessive 
issues  of  currency  or  credit.  They  may  be  due  to  physical 
causes  of  scarcity,  scanty  rainfall,  depredations  of  insect 
pests,  labor  troubles,  and  a  host  of  other  factors.  The 
remedy  for  such  a  situation  would  not  be  restricted  credit. 
Rather,  the  difficulties  due  to  such  causes  might  demand 
extra  advances  from  the  banks.  To  enable  the  producers 
to  avoid  financial  failure,  it  might  be  that  the  banks  would 
be  required  to  supply  the  funds  necessary  to  meet  current 
obligations. 


DEVELOPMENT,  MAY,  1920,  TO  PRESENT     33r 

It  has  been  mentioned  previously  that  there  arc  situa- 
tions in  which  slightly  rising  prices  exert  a  tonic  effect  upon 
industry.  Such  a  situation  might  be  that  following  a 
period  of  subnormal  activity.  Feileral  Reserve  policy 
should  be  adapted  so  far  as  possible  to  the  requirements  of 
productive  efficiency  and  not  to  those  of  price  stability. 
Over  a  series  of  years  the  volume  of  credit  grants  should  be 
such  as  would  lead  to  the  maximum  amount  of  produc- 
tion. The  final  test  of  the  discount  policy  must  be  what 
production  indices  show  regarding  the  effects  of  previous 
credit  grants.  If  the  curve  of  production  is  rising,  there  is 
justification  for  continued  liberality.  If  past  increases  in 
the  volume  of  credit  have  not  correlated  with  an  approxi- 
mately corresponding  enlargement  of  physical  production, 
the  situation,  in  the  absence  of  other  counteracting  facto r.-^, 
calls  for  restrictive  measures.  To  quote  from  a  previous 
statement  by  the  writer :  * 

Increase  in  the  volume  of  rediscounts  should  be  permitted 
so  long  as  the  main  effect  is  to  enlarge  the  volume  of  production 
and  not  to  raise  the  level  of  prices.  Decreases  in  rediscounts 
should  be  enforced  when  it  appears  that  the  volume  of  business 
and  consequently  the  need  for  credit  is  declining.  Over  a  long 
period  of  time  increases  in  rediscounts  should  be  apportioned 
to  the  natural  rate  of  growth  in  the  productive  capacities  of  the 
people.  To  express  the  matter  in  terms  of  the  equation  ol 
exchange  (P=il/F)^  M  should  be  altered  when  its  principal 
effect  will  be  borne  by  T  and  not  by  P. 

It  should  not  be  difficult  to  educate  the  public  to  this 
point  of  view.  In  every  review  of  the  month  the  pnxhic- 
tion  achievements  of  the  country  should  be  stressed  promi- 

'H.  L.  Reed,  "The  Work  of  the  Federal  Reserve  Board,"  Jourval  of  Political 
Economy,  January,  192 1,  p.  76. 

'  In  this  equation,  symbol  P  refers  to  the  price  level,  M  to  the  amount  of 
money  in  actual  circulation,  V  to  the  rapidity  with  which  the  avcra^je  unit  of 
money  circulates,  T  the  volume  of  trade  for  the  period. 


332  FEDERAL  RESERVE  POLICY 

nently.  Attention  should  bo  rallorl  to  the  amount  of  rrodit 
advances  for  previous  months  and  the  attempt  made  to 
analyze  their  effects.  Many  would  soon  get  in  the  habit  of 
justifying  credit  advances  according  to  their  effect  upon 
industrial  activity.  It  should  be  seen  that  in  a  period  of 
iabor  unemployment,  of  surplus  stocks  in  the  hands  of 
producers  and  dealers,  liberal  bank  loans  may  mean  pri- 
marily the  enlargement  of  production,  the  bringing  on  to 
the  market  of  goods  which  otherwise  would  not  be  created. 
In  an  opposite  situation,  one  of  full  labor  employment,  of 
shortage  in  supplies  and  materials,  the  effect  of  credit 
advances  should  be  higher  money  terms  on  which  business 
men  bid  for  the  scanty  supply  of  goods,  materials,  and 
labor.  Expansion  then  must  mean  price  inflation. 

In  other  words,  the  reserve  bank  which  increases  its 
operations  should  be  made  to  defend  its  action  on  the 
ground  that  more  credits  were  required  to  unlock  unused 
productive  resources.  The  writer  is  aware  that  the  de- 
tailed rules  for  such  a  policy  would  call  for  a  large  measure 
of  fine  discrimination  and  that  controversy  must  arise 
continually  in  their  application.  Nevertheless,  there  must 
be  a  correct  formulation  of  the  relation  of  increasing  bank 
credits  to  the  level  of  prices  and  the  volume  of  trade.  No 
ideal  solution  is  otherwise  possible. 

It  should  not  be  difficult  to  find  authority  in  the  act  for 
such  a  policy.  The  act  states  that  rates  should  be  fixed 
"with  a  view  of  accommodating  commerce  and  industry." 
In  so  far  as  commerce  and  industry  require  the  credits  to 
function  most  efficiently,  an  attempt  should  be  made  to 
render  them  available.  But  if  trade  and  production  can- 
not be  increased  in  approximately  corresponding  measure 
by  use  of  a  larger  volume  of  credit,  restrictive  measures 
should  be  employed.  It  should  be  easy  to  secure  assent  to 
these  principles  by  endeavoring -continuously  to  lead  the 


DEVELOPMENT,  MAY,  ig20,  TO  PRESENT     333 

public  to  compare  changes  in  the  vokimc  of  production 
with  those  in  the  volume  of  credit  and  currency. 

Decisions  regarding  the  justification  for  increasing 
credits  should  be  influenced  also  by  qualitative  considera- 
tions. In  every  season  of  unduly  rapid  activity  certain 
excesses  appear.  Commodity  and  security  speculation 
exceed  past  records,  borrowers  demand  repeated  renewals 
and  loans  of  greater  maturity,  the  liquidity  of  paper  in 
general  is  reduced.  By  means  of  statistical  comparisons 
with  the  usual  or  standard  conditions,  aid  could  be  had 
in  ascertaining  whether  there  is  justification  for  permitting 
the  volume  of  reserve  bank  advances  to  be  enlarged. 

At  the  present  time  there  is  a  wide  demand  that  as  a 
permanent  solution  reserve  banks'  rates  should  be  kept 
above  the  market  rates.  The  argument  is  that  the  reserve 
banks  should  not  contribute  permanently  any  large  part 
of  the  country's  credit  supply.  The  reserve  banks'  funds 
should  be  drawn  upon  only  to  meet  extraordinary  yearly 
or  seasonal  requirements.  It  is  insisted  that  they  should 
keep  out  of  the  market  except  in  such  situations.  When  a 
member  bank  rediscounts  with  a  reserve  bank,  it  should 
do  so  only  at  a  sacrifice.  This,  we  are  informed,  is  an 
accepted  principle  of  central  banking  procedure.  "Since 
1871,"  for  instance,  "there  has  not  been  a  single  year 
when  the  official  bank  rate  of  the  Bank  of  England  was 
not  above  the  market  rate  on  yearly  averages."  ' 

A  serious  difficulty  with  this  proposal  is  that  of  deter- 
mining which  of  the  various  interest  or  discount  rates 
should  be  taken  as  expressive  of  the  general  market  rate. 
Should  it  be  the  rate  on  line-of-crcdit  loans  or  should  it  be 
the  rate  on  bank  acceptances?  Regarding  this  a  Mil- 
waukee banker  states: 

•  Cf.  "The  Gold  and  Retliscount  Policy  of  the  Federal  Reserve  Ranks,"  by  A. 
Barton  Hepburn  and  Benjamin  M.  Anderson,  Economic  World,  July  23,  1921, 
p.  112. 


334  FEDERAL  RESERVE  POLICY 

The  volume  of  line-of-crcdit  loans  in  this  country  is  far  larger 
than  the  volume  of  bank  acceptance  credits,  but  it  may  be 
doubted  whether  the  rates  on  such  loans  are  as  competitive  as 
bank  acceptance  rates.  Bank  acceptance  rates  are  fixed  in  the 
open  market  and  are  published.  Line-of-credit  loans  are  not 
as  competitive  as  they  may  seem.  A  small  firm  commonly 
maintains  a  line  of  credit  only  at  its  own  bank.  Large  corpora- 
tions usually  have  lines  of  credit  not  only  with  their  home  banks 
but  with  large  banks  in  financial  centers,  not  necessarily  because 
they  can  secure  lower  rates,  but  because  no  one  bank  wants  to 
take  care  of  their  full  needs.  For  these  reasons  it  is  to  be  doubted 
whether  line-of-credit  loans  afford  as  good  an  index  of  money 
market  tendencies  as  the  bank  acceptance  rates.* 

Although  the  acceptance  rate  may  represent  best  the 
drift  of  the  market,  it  might  not  be  practicable  to  rely 
upon  it.  In  many  situations  line-of-credit  rates  are  far 
above  the  more  competitive  acceptance  rate.  A  Federal 
Reserve  rate  based  upon  the  acceptance  rate  might  not  have 
the  anticipated  effect  of  keeping  the  reserve  banks  out  of 
the  market  except  in  emergency  conditions.  A  reserve  rate 
based  upon  line-of-credit  rates,  on  the  other  hand,  might 
remain  too  uniform  instead  of  displaying  the  proper  degree 
of  flexibility. 

It  is  believed,  therefore,  that  no  conscious  effort  should 
be  exerted  to  make  this  the  fundamental  consideration.  A 
rate  fixed  on  the  basis  of  preserving  a  reserve  ratio,  ren- 
dered manageable  by  the  adoption  of  some  such  plan  as 
Miller's,  and  modified  according  to  production  indices, 
ordinarily  would  be  above  the  bank-acceptance  rate.  But 
as  to  how  high  above  this  rate  it  should  be,  this  proposal  ^ 
gives  no  information.  A  reserve  rate  kept  above  all  bank 
rates  in  all  communities  would,  frequently  at  least,  be  too 
high  to  be  workable.    A  reserve  discount  rate  kept  just 

'  See  W.  P.  G.  Harding,  "Principles  Governing  the  Discount  Rate,"  The 
Annals,  January,  1922,  pp.  183-89. 

» The  proposal  that  reserve  rates  be  kept  above  the  general  market  rate. 


DEVELOPMENT,  MAY,  1920,  TO  PRESENT     335 

above  the  open  market  commercial  paper  rate  might  not 
be  high  enough  to  be  effective. 

The  preceding  brief  discussion  is  designed  to  throw  some 
light  upon  the  question  as  to  when  reserve  bank  advances 
should  be  restricted.  Let  us  next  endeavor  to  ascertain 
the  means  which  should  be  employed  to  restrict  credits  on 
occasions  of  necessity.  Shall  principal  reliance  be  placed 
on  rate  increases?  Or,  will  it  be  necessary  to  insist  on 
direct  rejections  of  applications  on  the  basis  of  the  quality 
of  the  paper  offered?  Or,  finally,  must  greatest  measure  of 
attention  be  devoted  to  reserve  banks'  open-market 
operations? 

There  is  much  to  be  offered  in  behalf  of  reliance  upon 
rate  increases.  It  is  the  only  means  of  restricting  credit 
grants  which  does  not  subject  the  bank  to  charges  of  par- 
tiality. The  general  public  undoubtedly  has  no  adequate 
understanding  of  the  pressure  which  is  brought  to  bear 
upon  the  district  directorates  in  such  a  period  as  that 
following  the  fall  of  19 19.  Nothing  can  create  more  bitter 
criticism  than  the  feeling  that  the  bank  discriminates 
unjustlyagainst  some  portion  of  its  customers.  Particularly 
true  is  all  this  of  the  Federal  Reserve  banks.  Their  resources 
depend  upon  the  contributions  of  all  their  members.  Each 
member  bank  accordingly  feels  it  has  a  claim  upon  the 
resources  of  the  reserve  bank  on  occasions  of  need.  It  is  a 
requirement  of  policy  that  rate  increases  be  made  before 
other  measures  are  attempted. 

The  efficiency  of  rate  increases  may  be  considered  from 
two  points  of  view.  First,  will  a  higher  rate  exacted  by 
reserve  banks  l^e  reflected  in  an  increased  loan  rate  by 
member  banks?  Secondly,  will  an  increase  in  the  general 
market  rate  discourage  most  largely  desirable  or  undesir- 
able business  activities? 

For  a  time  a  certain  theory  was  current  which,  if  true, 


336  FEDERAL  RESERVE  POLICY 

would  have  dcniocl  the  effectiveness  of  the  rate-increase 
method.  Rediscounts  create  reserves  for  member  banks. 
For  every  dollar  of  reserve  money,  member  banks  may 
loan  six  or  seven  or  more  dollars  to  their  own  customers. 
Since  they  receive  interest  on  several  dollars,  must  "not 
the  discount  paid  on  the  one  dollar  obtained  from  the 
reserve  bank  be  a  minor  consideration?  Any  slight 
advance  in  rediscount  rates  would  appear  to  be  of  little 
effect.  To  be  really  effective  it  would  seem  that  the  reserve 
banks'  rates  must  be  absurdly  high,  as,  for  instance  twenty 
or  thirty  per  cent.  From  the  standpoint  of  commanding 
political  support  such  a  rate  would  be  impracticable. 

Answers  to  this  puzzling  question  were  several.  Some 
argued  that  rate  increases  would  be  effective  merely 
because  most  bankers  had  got  into  the  habit  of  comparing 
the  rates  they  receive  on  loans  with  the  rate  they  paid  on 
rediscounts.  If  the  reserve  bank  rate  was  the  higher,  loans 
to  customers  would  be  reduced.  It  was  held  to  be  not  so 
much  a  question  of  what  bankers  should  think,  but  what 
they  usually  did  think. 

More  complete  analysis,  however,  would  have  indicated 
that  there  was  little  or  no  profit  in  paying  a  higher  dis- 
count rate  than  that  at  which  the  funds  were  loaned.  As  a 
matter  of  fact  banks  cannot  loan  anything  like  six  or  seven 
or  eight  times  the  amount  of  credit  obtained  by  the  redis- 
counting  operation.  Inter-bank  relationships  render  this 
impossible. 

Suppose,  for  instance,  a  bank  rediscounts  sufficient 
paper  to  obtain  a  deposit  credit  of  one  dollar  with  a 
reserve  bank.  This  one  dollar  of  reserve  money  would 
enable  the  member  bank  to  loan  its  customers,  let  us  say 
ten  dollars  of  deposit  credits.  In  a  short  time,  however, 
checks  would  be  written  against  these  deposits,  and  many 
of  them  deposited  with  other  banks.  In  this  way  the  other 


DEVELOPMENT,  MAY.  1920,  TO  PRESENT     337 

banks  would  receive  the  rip^ht  to  dcmanfl  cash  from  the 
original  bank.  To  meet  these  demands  our  bank  would  be 
obliged  to  give  up  cash  or  engage  in  further  rediscounting. 
It  must  figure,  therefore,  if  its  reserve  was  insufficient 
originally,  upon  rediscounting  almost  as  many  dollars  as  it 
loaned  its  customers.  Because  of  this  fact,  banks  would 
lose  if  they  paid  a  rediscount  charge  very  much  greater  than 
that  received  on  their  own  loans. 

It  might  be  argued  that  the  loss  of  cash  to  other  banks 
need  not  occur  if  other  banks  were  expanding  their  loans 
as  rapidly  as  the  bank  we  have  in  mind.  Our  bank  would 
be  receiving  as  many  dollars  of  checks  drawn  upon  other 
banks  as  they  would  receive  against  it.  But  if  this  were 
the  situation,  the  loans  of  our  bank  prevent  it  from  gaining 
cash  through  a  favorable  clearing  house  balance.  Cash  it 
might  have  gained  in  this  way,  upon  being  deposited  with 
a  reserve  bank,  would  enable  it  to  loan  several  fold  its 
amount.  The  rediscount  finally  necessitated  the  cutting 
down  of  its  loans  to  an  approximately  equal  amount. 
Bankers  were  correct  in  refusing  to  admit  profits  unless 
they  receive  from  their  own  customers  approximately  the 
same  rate  they  pay  to  the  reserve  bank.' 

A  second  objection  to  the  efficacy  of  rate  increases  is 
based  upon  the  fact  that  many  loans  are  exceedingly  high, 
due  to  the  fact  that  they  are  not  subject  to  a  high  degree 
of  competition.  Many  borrowers  are  unable  to  offer  their 
paper  outside  their  own  community.  In  such  situations 
the  rates  charged  may  represent  some  degree  of  monopo- 
listic extortion.  It  is  well  known  that  in  many  newly 
developing  sections  of  the  South  and  West  it  is  customary 
for  banks  to  exact  a  charge  of  ten,  twelve,  fourteen  per 
cent.  As  a  matter  of  fact  there  may  be  some  justification 

'  For  a  more  clalxirate  discussion   of  this  matter  sec  Chester  A.  Pliiih'pa, 
Bank  Credit,  pp.  1-76. 


338  FEDERAL  RESERVE  POLICY 

for  such  high  rates.  The  volume  of  business  done  in  such 
communities  may  be  so  Hmited  as  to  necessitate  the  alloca- 
tion of  higher  overhead  charges  to  each  dollar  loaned.  But, 
in  such  non-competitive  situations,  it  would  seem  that  an 
advance  of  a  half  per  cent  or  so  in  rediscount  rates  might 
be  a  negligible  consideration. 

There  is  much  to  offer  on  the  other  side,  however.  It  is 
questionable  the  extent  to  which  the  abuses  of  over-rapid 
credit  expansion  arise  in  such  communities.  Commodity 
and  security  speculation,  the  securing  of  capital  for  new 
industrial  enterprises,  in  general  the  activities  at  the  basis 
of  a  boom,  are  financed  much  more  largely  by  funds 
obtained  from  banks  in  the  larger  cities  where  competitive 
conditions  do  prevail.  With  money  dear  in  these  places, 
unduly  rapid  industrial  activity  might  be  discouraged  to  a 
greater  or  less  degree  regardless  of  what  takes  place  in  the 
smaller  localities. 

By  the  application  of  the  principle  of  progressive  rates, 
moreover,  banks  even  in  these  non-competitive  communi- 
ties might  be  made  to  feel  the  efTect  of  the  reserve  bank's 
rate  increase.  Authority  for  the  establishment  of  a  pro- 
gressive rate  schedule  has  existed  since  the  Phelan  Bill 
became  law  on  April  13,  1920.  According  to  the  terms  of 
this  bill  rediscount  rates  may  be  increased  for  those  mem- 
ber banks  whose  rediscounts  exceed  a  specified  base  line  to 
which  the  normal  rate  applies.  During  the  latter  part  oi 
1920  effective  use  was  made  of  this  plan  in  two  districts. 
In  some  cases  member  banks'  applications  were  made  as 
high  as  nine  per  cent  for  a  portion  of  their  borrowings. 

The  progressive-rate  plan  has  not  been  highly  popular, 
and  during  the  period  of  its  application  there  was  a  more 
or  less  general  demand  for  its  abolition.  Some  such  meas- 
ure, however,  seems  necessary  if  rate  increases  are  to  be 
made  effective  in  communities  where  strong  competition 


DEVELOPMENT,  MAY,  1920,  TO  PRESENT     339 

does  not  prevail.  In  situations  demanding  strict  control  of 
credit,  inability  to  employ  it  may  necessitate  the  use  of 
other  undesirable  measures,  such  as  the  downright  refusal 
to  accept  certain  paper  regardless  of  the  amount  of  the  dis- 
count that  would  be  paid. 

Many  of  the  doubts  regarding  the  effectiveness  of  rate 
increases  are  based  upon  the  experience  of  the  system 
during  the  latter  half  of  1920  during  which  reserve  ad- 
vances increased  despite  higher  rates.  But  so  over-ex- 
tended had  most  banks  become  in  the  preceding  boom 
period  that  the  process  of  liquidation  was  attended  with 
great  difficulty.  There  is  general  agreement  that  the  rate 
increases  of  that  year  prevented  the  volume  of  advances 
from  becoming  as  large  as  otherwise  they  would  have  been. 
It  is  not  expected  that  many  situations  similar  to  those 
facing  the  reserve  administration  in  the  spring  of  1920  will 
arise  in  the  future.  The  credit  and  industrial  situation  at 
that  time  was  intolerable.  But  it  was  due  in  large  measure 
to  the  previous  inability  of  the  reserve  banks  to  raise  rates 
because  of  the  Treasury's  easy  money  programme. 

It  may  be  that  the  effect  of  rate  increases  will  be  most 
largely  sentimental;  that  they  are  effective  only  in  so  far 
as  they  give  hint  of  the  determination  of  the  administra- 
tion to  resort  to  stricter  and  more  direct  methods  in  the 
future.  If  this  be  true,  it  becomes  necessary  to  develop 
standards  for  the  application  of  methods  designed  to 
eliminate  unessential  paper.  Such  standards,  however, 
should  not  be  impossible  of  determination  on  the  part  of 
the  district  directorates.  The  former  Director  of  the 
Division  of  Analysis  and  Research  of  the  Federal  Reserve 
Board  has  suggested  that  the  proper  test  is  that  of  liquid- 
ity. He  states:' 

'  See  H.  Parker  Willis,  "Discrimination  in  Inflation,"  Commercial  and  Finan- 
cial Chronicle,  Scptcnit)cr  11,  iy20,  pp.  1040-41. 


340  FEDERAL  RESERVE  POLICY 

If,  for  example,  it  should  appear  that  a  borrower  had  fallen 
into  a  way  of  business  which  required  the  extension  of  a  longet 
and  longer  credit  to  customers,  or  that  he  was  drawing  upon 
securities  of  which  he  might  stand  possessed  in  order  to  protect, 
or  collateral  paper  which  he  was  keeping  practically  permanently 
in  bank,  or  for  which  he  was  asking  repeated  renewals,  the  situ- 
ation would  be  such  as  to  raise  a  strong  presumption  against  the 
essentiality  of  his  borrowing. 

But  whatever  the  proper  standards,  they  can  be  developed 
for  use  in  situations  where  rate  increases  may  not  succeed 
in  accomplishing  their  purpose. 

In  a  brilliant  article  in  the  American  Economic  Review^ 
Miss  Anna  Youngman  argues  that  the  warning  effect  of 
rate  increases  cannot  be  sufificient  unless  it  is  known  that 
the  reserve  banks  possess  the  power  to  break  local  rates 
which  remain  high  in  spite  of  the  discount  policy  of  the 
reserve  bank.  She  insists  that  rate  increases  cannot  be 
effective  if  the  local  banks  previously  have  been  exacting 
much  higher  charges  than  those  of  the  reserve  banks.  In 
such  situations  the  warnings  of  the  reserve  banks  will  be 
ignored.  Accordingly  she  advocates  the  extension  of  the 
open-market  powers  of  the  reserve  banks  to  include  the 
promissory  note  as  well  as  the  bill  of  exchange.  If  reserve 
banks  were  empowered  to  deal  directly  in  the  prevailing 
type  of  paper,  they  would  be  in  a  position  to  keep  rates  sa 
closely  in  touch  with  those  of  the  reserve  banks  that 
advances  in  the  latter  should  prove  more  effective. 

As  mentioned  previously,  however,  such  a  course  would 

be  politically  hazardous.  Nothing  creates  a  greater  degree 

of  animosity  toward  the  reserve  system  than  the  feeling 

that  the  district  banks  are  competing  with  the  member 

banks  by  using  funds  contributed  by  the  latter.    The 

weapons  of  the  reserve  system  to-day  are  not  perfect.  But 

'  Issue  of  September,  1921,  pp.  466-85.  "The  Efficacy  ot  Changes  in  the  Rates 
of  the  Federal  Reserve  Banks." 


DEVELOPMENT,  MAY,  1920.  TO  PRESENT     341 

it  is  believed  they  will  be  more  powerful  in  ordinary  situa- 
tions than  it  is  generally  felt.  As  reiterated  often,  the 
reserve  banks  could  exercise  no  real  control  over  the  loan 
market  in  the  post-war  boom  period.  Requirements  of 
Government  finance  were  then  the  dominant  considera- 
tions. Rather  than  increase  the  reserve  banks*  power  to 
compete  at  all  times  more  largely  with  member  banks,  it 
may  be  more  expedient  for  the  present  to  grant  them 
further  weapons  in  the  use  of  their  discount  facilities.  It 
may  be  preferable  to  permit  them  to  "enforce  reasonable 
regulations  regarding  usury  or  to  refuse  rediscounts  to  a 
bank  that  lends  at  extortionate  rates."* 

The  preceding  discussion  has  emphasized  the  fact  that 
an  important  question  is  the  extent  to  which  increases  in 
reserve  bank  rates  could  be  passed  on  to  the  business 
public.  To  what  degree  would  higher  rates  discourage  the 
public's  demand  for  loans?  It  has  been  argued  frequently 
that  American  business  is  commonly  conducted  on  the 
basis  of  such  liberal  margins  above  cost  that  higher  rates 
might  not  have  the  effect  of  limiting  seriously  the  demand 
for  credit.  In  the  final  analysis,  however,  all  this  would  1x3 
a  concern  merely  of  the  member  banks.  Member  banks 
in  the  same  manner  as  reserve  banks  desire  to  avoid  direct 
refusals  of  loan  operations.  They  would  first  proceed  very 
likely  on  the  basis  of  rate  increases.  But  if  the  rate  in- 
creases did  not  lessen  the  demand  for  loans,  direct  meth- 
ods, however  unpopular,  must  be  employed.  This,  how- 
ever, would  not  be  a  responsibility  of  the  reserve  banks.  It 
would  be  a  problem  solely  for  the  member  banks. 

It  may  be  true  that  rate  increases  would  not  be  ideal  in 
that  they  do  not  distinguish  between  socially  desirable 
and  socially  undesirable  demands  for  credit.  Rate  in- 
creases would  impose  the  same  handicap  upon  all  regard- 

•  American  Economic  Review,  ScijIlihIjlt,  i<>ji,  p.  478. 


342  FEDERAL  RESERVE  POLICY 

less  of  the  quality  of  the  economic  service  rendered  by  the 
borrower.  It  may  be  true  that  higher  rates  can  be  with- 
stood more  easily  by  the  borrower  whose  services  are  the 
least  necessary  to  society.  The  margin  of  profit  may  be 
greater  in  the  field  of  commodity  speculation  or  in  the  sale 
of  adulterated  goods.  But  it  is  impossible  for  the  reserve 
management  to  attempt  to  distinguish  between  the  legiti- 
macy of  the  various  demands  for  credit.  This,  to  repeat, 
is  a  problem  primarily  for  the  member  bank. 

It  is  not  believed,  therefore,  that  the  time  is  ripe  to 
grant  further  weapons  to  the  reserve  banks.  What  is  most 
necessary  now  is  that  some  means  be  found  which  will 
relieve  the  reserve  banks  from  undue  pressure  to  grant  in 
the  next  boom  period  all  the  credits  their  present  huge 
reserves  would  render  possible.  Two  things  in  the  writer's 
opinion  need  now  to  be  emphasized.  First,  the  reserve 
ratio  should  be  made  more  manageable  by  transferring  to 
the  note  reserves  all  reserve  money  except  that  which 
forms  a  workable  basis  for  advances  to  member  banks. 
Secondly,  no  opportunity  should  be  overlooked  to  con- 
vince the  public  that  an  increase  in  the  credit  volume  is 
defensible  only  when  it  is  necessary  to  give  full  play  to  the 
country's  productive  powers.  The  effect  of  credit  upon 
production  should  be  most  closely  observed.  Production 
indices  should  be  given  a  position  of  prominence  in  every 
issue  of  the  Bulletin. 

The  reserve  system  has  been  well  managed.  Although 
its  policy  has  been  developed  in  the  stormiest  years  of 
American  financial  history,  concessions  have  not  been 
made  destructive  of  its  power  and  influence.  Despite 
present  attacks  there  is  no  doubt  but  that  it  has  come  to 
command  the  respect  of  the  thinking  American  public. 
Bitter  critics  should  remember  that  there  has  not  yet  been 
a  period  in  its  existence  when  the  general  situation  would 


DEVELOPMENT,  MAY,  1920,  TO  PRESENT     343 

permit  the  formation  of  ideal  policies  for  future  credit 
control.  The  present,  accordingly,  is  not  the  time  to  grant 
compromise  to  the  advocates  of  easy  money  and  cheap 
credit.  The  system  must  be  fortified  to  meet  the  demands 
of  the  coming  period  of  industrial  revival.  In  that  period 
will  be  tested  the  ability  of  the  American  people  and  of 
the  reserve  administration  to  adapt  the  powers  of  a  won- 
derful financial  mechanism  to  the  requirements  of  present- 
day  business  and  industr>'. 


THE  END 


INDEX 


Acceptance,  trade,  development  of, 
105-27;  bank,  development  of, 
154-84;  foreign-trade  and  domes- 
tic-trade, 169-71,  194,  195.  See 
Bank,  Trade. 

Adams,  L.  R.,  quoted  on  deducting 
exchange,  37,  38. 

Advances,  of  reserve  banks,  redis- 
counts, 70-96;  direct  collateral,  to 
member  banks,  97-104;  note  is- 
sues, 205-20;  of  reserve  bank 
deposits  and  reserves,  221-38.  See 
Deposits,  Note  issues.  Redis- 
counts, Reserves. 

Agricultural  credit,  characteristics  of, 
128,  130,  132;  restrictions  on  loans 
on  real  estate,  128-30,  133,  134; 
need  of  commercial  bank  for  farm- 
ers, 131,  132;  provisions  in  Reser\'e 
Act  relative  to,  134-37. 

Agricultural  paper,  eligibility  of,  137- 
42;  identification  of,  142,  143;  six- 

'.  months,  rate  of  discount  on,  146, 
147. 

Agriculture,  legitimate  needs  of, 
not  neglected,  148-50;  extent  of 
hostility  encountered  by,  148.  See 
Farmers. 

Aldrich  Bill,  the,  2. 

Aldrich-Vrccland  Act,  the,  221,  222, 
242. 

American  Acceptance  Council,  123. 

Anderson,  B.  M.,  quoted  on  jiroba- 
bility  of  decline  in  prices,  295. 

Arbuthnot,  Professor  C.  C,  quoted 
on  banking  resources,  74. 

Asset  currency,  attempts  to  secure, 
205-08,  221. 

Atlanta  Reserve  Bank,  and  Supreme 
Court  decision  concerning  cashing 
of  checks,  36-38. 


Balances,  minimum,  46. 

Baltimore  jjlan,  the,  221. 

Bank  acceptances,  essential  function 
of,  154;  in  import  trade,  155,  I5(); 
in  export  trade,  156-58;  advan- 
tages of,  158-60;  types  of  trans- 
actions in  which  it  is  permitted, 
160,  162;  restrictions  on  use  of, 
161-65;  conditions  governing  use 
for  permitted  purposes,  165-69; 
foreign  and  domestic  trade,  iden- 
tification of,  169-71;  classes  of 
domestic,  permitted,  171-73;  re- 
strictions governing  power  of  re- 
serve banks  to  accept,  173-75; 
syndicate  acceptance,  175-80; 
policy  in  encouragement  of  use  of, 
180-82;  decline  in,  182,  183;  future 
development  of,  183,  184. 

Bank  notes,  issuing  of,  confinctl  to 
reserve  banks,  209;  bond- sec urc<l, 
211,  212;  cause  of  increased  cir- 
culation of,  212-14;  Federal  Re- 
serve, and  Federal  Reserve  notes, 
213,  214;  issuance  of,  under  .Al- 
drich-V'reeland  Act,  242,  243. 

Bankers'  acceptances,  191. 

Bankers'  bank,  1-3,  105,  106. 

Banking  systems,  of  Europe  and 
.America,  107. 

Banks,  germ  of,  in  note  issues  and 
fici)OsIts,  205. 

Barron,  C.  W.,  quoted  on  distribu- 
tion of  funds,  246. 

"Based  on  live  stock,"  ruling  of 
Board  on,  137. 

Bills  of  exchange,  before  the  Civil 
War,  107;  advantages  urgc<l  in 
behalf  of  encouraging  use  of,  1 1 1- 
14;   an    open-market    pa[)cr,   km. 

Bun<ls,  and  bank  notes,  of  national 


346 


INDEX 


banks,   209-12;    involve    present 
burden,  288,  289;  prices  of,  301- 

03. 
Book  credits,  225,  237. 
"  Buy-a-Bale-of-Cotton  "  movement, 

242. 

Cable  Transfers,  195. 

Capital,  definition  of,  85,  86. 

Cash  reserves,  ratio  of,  to  net  de- 
posits and  Federal  Reserve  notes, 
276. 

Central  bank,  fears  of,  2;  emergency 
character  of,  6;  arguments  for  and 
against,  105,  106;  question  of 
necessity  of,  125;  and  bank  note 
issues,  209.  '  *• 

Checks,  collections  and  clearances  of, 
importance  of,  20;  indicate  need 
of  continuous  operation  of  reserve 
banks,  20;  difficulties  of,  prior  to 
1914,  21-25;  indirect  routing  of, 
22-24;  exchange  exactions,  25-28; 
provisions  of  act  dealing  with 
collections  and  clearances  of,  28, 
29;  means  of  absorption  of  charges, 
29,  30;  methods  of  collecting  and 
clearing,  at  first  various,  30;  volun- 
tary-reciprocal plan  of  clearances, 
31,  32;  new  system  of  clearances 
beginning  operations  July  15,  1916, 
33;  attempts  at  coercion  in  connec- 
tion with  new  system,  34-36;  Su- 
preme Court  decision  concerning 
method  of  cashing,  36-39;  the 
Hardwick  Amendment,  40,  41; 
attitude  of  banks  toward  Board's 
clearance  plan,  41,  42;  conclusions 
regarding  par  collections  contro- 
versy, 45-49;  extent  of  use  of,  207. 

Circulating  medium,  demand  for, 
208. 

City  banks  and  country  banks,  ex- 
change exactions,  25-28,  45-49. 

Clearances,  check.  See  Checks, 
Collections. 

Clearing  house  certificates,  243. 

Clearing  house  functions,  and  Fed- 
eral Reserve  Board,  28,  29. 


Clearing  houses  and  clearing  systemB, 
before  1914,  20. 

Collateral  loans,  100-04. 

Collections,  check,  difficulties  of, 
prior  to  1914,  21-25;  provisions 
dealing  with,  28,  29;  voluntary- 
reciprocal  plan  of,  31,  32;  new 
system  of,  33;  attitude  of  banks 
toward  Board's  plan  of,  41,  42; 
extension  of  system  to  time  items, 
44,  45;  conclusions  regarding  par 
collections  controversy,  45-49. 

Commercial  bank,  the  farmer's  need 
of,  131,  132. 

Commercial  paper,  definition,  85,  86. 

Commodities,  prices  of,  278,  298. 
See  Prices. 

Commodity  rate,  143-46. 

Contract  for  sale,  87,  88. 

Cooperative  credit  institutions,  131, 
132. 

Cotton,  at  time  of  Great  War,  241, 
242. 

Cotton  loan  fund,  242. 

Country  banks  and  city  banks,  ex- 
change exactions,  25-28,  45-49. 

Credit,  regional  system  susceptible 
to  expansion  of,  5,  6;  principles  of 
control  needed,  19;  agricultural, 
under  the  Federal  Reserve,  128- 
53;  two  forms  of,  note  issues  and 
deposits,  205;  way  open  for  ex- 
pansion of,  by  amendment  of  June 
21,  1917,  237;  bank,  on  November 
23,  1917,  271-73;  delayed  process 
of  war  mobilization,  285;  period  of 
post-war  expansion  of,  292-315; 
and  prices,  as  bearing  on  Reserve 
policy,  299-311;  and  production 
314,  342;  bases  of  control  of,  323- 
35;  means  of  restricting,  335;  and 
rate  increases,  335-41. 

Credits,  book,  225,  237. 

Currency,  volume  of,  relation  to 
price  level,  306. 

Dairy  cattle  paper,  141,  142. 
Delano,  F.  A.,  quoted  on  purpose  of 
reserve  system,  248,  252. 


INDEX 


347 


"Department  store"  banking,  68. 
Deposits,  a  form  of  credit,  205; 
increase  of  importance  of,  207; 
recognition  of  need  of  elasticity  of, 
208;  demand  and  time,  223,  224; 
with  reserve  banks,  methods  of 
establishing,  224,  225;  net,  the 
law's  definition  of,  238;  effect  of, 
on  prices,  306,  307, 

Depreciation  of  the  dollar,  200,  201. 

Discount,  on  ninety-day  paper,  rates 
of,  320. 

Discount  operations,  and  open- 
market  operations,  comparative 
volume  of,  196;  of  newly  estab- 
lished Federal  Reserve  banks,  245. 

Discount  rates,  acceptance  and  line- 
of -credit,  333-35.  See  Rates, 
Rediscounts. 

Discountable  paper,  regulations  re- 
garding, 82-S5. 

Discounts,  direct,  not  permissible  at 
first,  97;  reasons  for  discrimination 
against,  97-99;  arguments  for,  99; 
amendment  permitting  collateral 
loans,  100;  use  of  direct  collateral 
loan,  loi,  102;  advantages  of  di- 
rect loans,  102-04;  in  first  years  of 
the  system,  253-57. 

District  directorate,  responsibility  of, 
16,  17;  and  member  banks,  close- 
ness of  contact  of,  18. 

Dollar,  depreciation  of,  201,  202. 

Dollar  exchange,  165,  166,  189,  203. 

Domestic-trade  and  foreign-trade  ac- 
ceptances, 136,  169-71,  194,  195. 

Double  name  and  single-name  paper, 
75-82,  107-11. 

Draft,  in  slow  accounts,  109;  trade 
acceptance  in  form  of,  115,  116; 
status  of,  for  goods  to  be  used,  121 ; 
can  be  peddled,  136;  for  foreign 
trade, 166-69. 

Draining  and  tilling,  notes  for,  140, 
141. 

Earning  assets,  320. 
Edge  Act,  177,  178,  180. 
Elliott,  M.  C,  quoted,  122. 


Emergency  relief,  or  continuous 
operation,   question    of,    245-49. 

European  banking  methods,  and 
American,  107. 

Evans,  Judge  Beverly  D.,  his  opin- 
ion concerning  collection  of  checks, 
38. 

Exchange  exactions,  25-28;  means 
of  absorbing,  29,  30;  Mississippi 
law  concerning,  35,  36;  effect  of 
Supreme  Court  decision  concerning 
cashmg  of  checks,  36-39;  and 
Hardwick  amendment,  40,  41; 
attitude  of  banks  toward  Board's 
plan,  41,  42;  legal  warrant  for,  43, 
44;   conclusions  regarding,  45-49. 

Export  trade,  use  of  trade  accept- 
ances in,  156-58. 

Farmers,  discontent  with  rescr\-e 
system,  151-53.  See  Agriculture, 
Agricultural. 

Federal  Reserve  Act,  the  Hardwick 
amendment,  40,  41 ;  amendment  of 
June  21, 1917, 66, 231-33,  237,  238, 
263,  277;  amendment  of  Septem- 
ber 7,  1916,  100,  176,  230;  provi- 
sions in,  relative  to  agricultural 
credit,  134-37;  permitting  national 
banks  to  accept  for  domestic  pur- 
poses, 195;  amendment  of  Sep- 
tember 17,  1919,  176;  amendment 
of  December  24,  1919,  177;  Ix;- 
comes  law,  240.  "^ 

Federal  Reserve  bank  notes  and 
Federal  Reserve  notes.  See  Note 
issues,  Notes. 

Federal  Reserve  Banks,  emergency 
character  of,  6,  7;  begin  operation, 
244,  245;  questions  of  policy  con- 
cerning, 245;  for  continuous  oper- 
ation, 245-49;  earnings  for  1915 
and  1916,  257,  25H;  operations, 
compared  with  those  of  private 
institutions,  258.  See  Reserve 
Banks. 

Federal  Reserve  Board,  and  the 
(juestion  of  regional  rcsi>onsibiIity, 
16,  i7;andFctirral  Reserve  Banks, 


348 


INDEX 


17,  18;  and  clearing  house,  28,  29; 
regulations  of,  regarding  discount- 
able paper,  82-85;  appointment  of 
members  of,  240;  cooperated  with 
the  Treasury  during  the  War,  267- 
70;  cooperation  with  the  Treasury 
a  proper  proceeding,  289-91 ;  credit 
system  of,  299,  307.   See  Credit. 

Federal  Reserve  Clearing  System, 
278  n. 

Federal  Reserve  System,  district  re- 
serve banks  the  most  character- 
istic feature,  of,  l;  the  underlying 

,  theory  of,  2;  general  considera- 
tions concerning  admission  into, 
50-52 ;  national  banks  and,  52 ;  con- 
ditions of  membership  in,  for  State 
banks,  52,  53;  reasons  for  unwill- 
ingness of  State  banks  to  join,  54- 
64;  appeal  for  entrance  of  State 
Banks  into,  65,  66;  increased  mem- 
bership of  State  banks  in,  67; 
considerations  on  State  bank 
membership,  67-69;  periods  of, 
239;  not  in  operation  at  beginning 
of  Great  War,  243,  244;  meant 
to  operate  continuously,  245-49; 
difficulties  of  getting  into  the 
market,  249-52;  rate  policy,  252, 
253;  discounts  in  first  years,  253- 
57;  open-market  purchases  in 
1915  and  1916,  256,  257;  state- 
ment of  policy  during  first  period, 
258-60;  in  the  industrial  depres- 
sion   of    1920-21,  320-22;   future 

^^  policy  of,  322,  331,  342,  343. 

"Float,"  24,  25,  226. 

Foreign  branches,  of  American  banks, 
I75»  176. 

Foreign-trade  and  domestic-trade 
acceptances,  169-71,  194,  195. 

Foreign  Trade  Financing  Corpora- 
tion, 179. 

Gold,  accumulating  in  reserve  banks, 
227-30,  235-37;  in  reserve  banks, 
efficiency  of,  233,  234;  inflow  of, 
235;  holdings  of,  increased,  237, 
264,  265,  275,  276. 


Gold  Settlement  Fund,  relation  of, 
to  inter-district  shifting  of  funds, 
10  71.,  29;  enlargement  of  functions 
of,  45;  establishment  of,  259;  and 
;..iter-bank  balances,  278  n. 

Government  bonds,  190,  194,  250. 

Harding,  Governor,  quoted  on  duties 
of  Federal  Reserve  Banks  and 
Federal  Reserve  Board,  17,  18; 
his  attitude  toward  the  Board's 
clearance  plan,  42;  opposed  to 
plan  of  Senator  Owen,  203;  on 
Federal  Reserve  control  of  banking 
situation,  261;  on  notes,  270;  on 
currency-volume  and  price  level, 
306. 

Holmes,  George  K.,  37,  130. 

Implement  paper,  eligibility  of,  138, 
139,  142. 

Import  trade,  use  of  trade  accept- 
ances in,  155,  156. 

Industrial  reaction  of  1920-21,  316- 
22. 

Inflation,  price,  during  the  War, 
278-84;  due  to  method  of  financ- 
ing the  War,  284-91;  after  the 
War,  295-99.    See  Prices. 

Inter-district  lending  of  funds,  9- 
14. 

Investment  operations  of  reserve 
banks,  in  1917  and  1918,  273,  274. 

Investment  paper,  objections  to 
rediscount  of,  72-75;  criterion  of, 
85-93;  and  open-market  opera- 
tions, 190. 

Investment  trust,  177. 

Irrigation,  191. 

Jones,  Mr.,  of  the  Federal  Reserve 
Board,  240. 

Kemmerer,  Professor  E.  W.,  130. 

LeffingAvell,  R.  C,  quoted,  on  rates, 
301-03;  on  reserve  ratio,  326,  327. 

Live-stock  paper,  137,  138,  141, 
142. 


INDEX 


349 


Loans,  collateral,  100-04;  real 
estate,  National  and  State,  restric- 
tions on,  128,  130,  133,  134;  cfTect 
of  rates  on,  341,  342. 

McAdoo,  Secretary,  quoted  on  en- 
trance of  State  banks  into  Federal 
Reserve  System,  65. 

Member  banks,  and  district  direc- 
torates, 18;  State  banks,  50-69; 
advances  to,  in  form  of  rediscounts, 
70-96;  direct  collateral  advances 
to,  97-104;  restrictions  on  their 
power  to  accept  bank  acceptances, 
167-73;  and  redemption  of  bank 
notes,  215-17;  reserves  of,  222- 
24;  methods  of  establishing  de- 
posits with  reserve  banks,  224, 
225;  and  book  credits,  225;  reserve 
percentages  for,  225-27,  232,238; 
legal  reserves  of,  to  be  held  entirely 
on  deposit  with  reserve  lianks,  231, 
232,  263;  and  the  question  of 
capital  stock  subscriptions,  250-52 ; 
conditions  of,  in  second  period, 
265,  266;  reserve  account  of,  in 
1917  and  1918,  274;  elTect  of  War 
on  operations  of,  276,  277. 

Miller,  A.  C,  quoted  on  wages  and 
cost  of  living,  305;  his  plan  of 
credit  control,  325-30. 

Mississippi  law,  as  regards  exchange, 

35.  3^>- 

Mitchell,  Professor  Wesley  C,  279. 

Mortimer,  Frank  C,  quoted  on  re- 
turn of  capital  stock  subscrip- 
tions, 250,  251. 

Moulton,  Mr.,  quoted,  79. 

Municijxil  Ijonds,  194. 

Municipal  warrants,  250. 

National  banks,  membership  of,  52; 

legislation   broadening  jKnvers  of, 

68;  bonds  and  bank  notes  of,  209- 

12,  220. 
National  Reserve  Association,  2. 
Net  deposits,  the  law's  definition  of, 

238. 
Note  issues,  a  form  of  credit,  205; 


developed  before  deposits,  206; 
subject  to  strict  regulations  by 
National  Banking  Act,  206;  elas- 
ticity of,  208;  concentrated  in 
hands  of  reserve  banks,  209;  of 
Federal  Reserve  notes,  214;  method 
of,  214-16;  elTect  of,  on  prices, 
^  306,  307. 

Notes,  bank,  issuing  of,  confmcfl  to 
reserve  banks,  2(K);  bond-secured, 
211,  212;  cause  of  increased  circu- 
lation of,  212-14;  issued  to  replace 
standard  silver  dollars  destroyed, 
213;  issuance  of,  under  AUlrich- 
Vrceland  Act,  242,  243. 

Notes,  farmers',  137-42.  See  Agri- 
cultural credit. 

Notes,  Federal  Reserve,  issuance  of, 
by  Act  of  1913,  214;  receival)le 
by  member  and  reserve  banks, 
215;  lien  behind,  215;  issued 
through  rediscounts,  215,  216; 
return  of ,  2 1 6,  2 1 7 ;  interest  charges 
on,  217;  outstanding  of,  218-20; 
most  important  element  in  our 
general  circulation,  220;  made  more 
acce[)lablc  by  amendment  of  Sep- 
tember 7,  1916,  231;  substitution 
of,  for  gold,  235;  to  be  counted 
as  part  of  vault  reserves,  236;  take 
place  of  legal  tender,  237;  changes 
in  circulation  of,  for  various  dates, 
274,  320;  gold  co\er  for  circulation 
of,  275;  effect  of,  on  prices,  306, 
307. 

Open  book  account  system,  108. 

Open-market  operations,  and  dis- 
count operations,  difference  be- 
tween, 185-87;  extension  of,  to 
reserve  banks,  185;  reasons  for 
inclusion  of,  in  final  bill,  187-89; 
on  (luoiing  forward  discount  rates, 
189,  190;  classes  of  paper  per- 
mitted in,  190,  191;  as  regards 
maturity  of  bankers'  acceptances, 
192,  193;  as  regards  dealings  in 
cal)le  transfers  and  gold  coin  and 
bullion,  193;  as  regards  purchase  of 


350 


INDEX 


acceptances,  194,  195;  compara- 
tive volume  of,  196;  ol>jections  to, 
196-200;  proposal  for  seijarate 
reserve  bank,  200-04;  during  1915 
and  1916,  256,  257. 

Organization  Committee,  240. 

Owen,  Senator,  quoted  on  abdica- 
tion of  Board,  16;  his  proposal  for 
separate  reserve  bank,  200-04. 

Perrin,  John,  quoted  on  direct  dis- 
counts, 98. 

Phelan  Bill,  338. 

Pittman  Act,  212-14. 

Prices,  wholesale,  rise  of,  in  period 
1917-1918,  278-80;  retail  rise  of, 
in  period  1917-1918,  279,  280; 
relationship  between  media  of 
exchange  and,  280-82;  results  of, 
282-84;  due  to  method  of  financing 
the  War,  284-91;  after  the  War, 
295-99;  relation  of,  to  volume  of 
currency.  306;  factors  determining, 
307;  and  bankcredits,  308-11;  as 
affected  by  enlarged  money  de- 
mand, 309;  in  industrial  reaction 
of,  1920-1921,316-22;  stability  of, 
as  test  for  rediscount  policy,  324, 
325,  330-32. 

Production,  as  guide  to  future  Fed- 
eral I-leserve  policy,  331-33;  and 
credit,  342. 

Rates,  5-7;  commodity,  143-46;  dis- 
count, quoting  forward,  189,  190; 
policy  of  Board  in  regard  to, 
marked  by  conservatism,  252, 
253;  on  commercial  paper,  in- 
creased, 263,  264;  from  May, 
1917,  to  November  11,  1918, 
268-70;  rediscount,  303-05,  311- 
15;  of  discount  on  ninety-day 
paper,  320;  of  reserve  banks,  and 
market  rates,  333;  acceptance  and 
line-of -credit,  333,  334;  reliance 
on,  as  means  of  restricting  credit 
(progressive  rate  plan),  335-41; 
effect  of,  on  demand  for  loans, 
34^.  342. 


Real  estate  loans,  National  and 
State    restrictions   on,    128,    130, 

133,  134- 

Reclamation  districts,  191. 

Rediscounts,  cooperative  function  of 
reserve  banks,  70,  71;  provisions 
regarding,  71,  [72;  of  speculative 
and  investment  paper,  objections 
to,  72-75;  single-name  and  double- 
name  paper,  75-82;  regulations 
regarding  discountable  paper,  82- 
85;  determination  of  eligible  paper, 
85-93;  the  question  of  limitations, 
93-96;  and  direct  discounts,  97,  98; 
rate  of,  on  six-months  agricultural 
paper,  146,  147;  no  great  demand 
for,  at  first,  250;  rates  of,  303-05, 
311-15;  control  of, essentialsshould 
be  developed,  322;  policy,  reserve 
ratio  as  guide  for,  324,  325,  327- 
30;  policy,  price  stability  as  test 
for,  324,  325,  330-32;  increase  in 
rates  of,  as  means  of  restricting 
credits,  335-41- 

Reed,  H.  L.,  articles  of,  quoted,  286, 
287,  309,  331. 

Regional  banks,  system  of  twelve,  2. 

Regional  responsibility,  16,  17. 

Regional  system,  surprising  outcome 
of  legislative  planning,  i ;  state- 
ment of  objections  made  to,  3-5; 
consideration  of  objections  to,  5- 
18;  and  credit  expansion,  5,  6;  and 
continuous  functioning,  6,  7;  and 
rates,  6, 7;  and  sectionalism,  8;  and 
inter-district  harmony,  9-14;  and 
complaints  of  sectional  partiality, 
14-16;  and  regional  responsibility, 
16,  17;  merits  of,  18;  most  vulner- 
able point  of,  18. 

Renewal  trade  draft,  122. 

Reserve  account,  of  member  banks, 
320. 

Reserve  bank,  proposal  for  separate, 
200-04. 

Reserve  banks,  and  check  collections 
and  clearances,  20-4q;  advances 
of  rediscounts,  70-96;  condition 
governing  the  power  of,  to  acquire 


INDEX 


351 


acceptances,  173-75;  open-market 
operations  of,  185-204;  advances 
of,  note  issues,  205-20;  advances 
of,  deposits  and  reserves,  221-38; 
their  bank  credits  with  member 
banks,  225;  reserve  percentages 
for,  225;  efficacy  of  gold  in,  233, 
234;  and  the  question  of  capital 
stock  subscriptions,  250-52;  re- 
serves of,  264;  investment  opera- 
tions of,  273,  274;  earning  assets 
of,  274;  ratio  of  cash  reserves  to 
net  deposits  and  Federal  Reserve 
notes,  276;  relation  of,  to  other 
parts  of  system,  should  be  for- 
mulated, 322;  surplus  reserves  of, 
enormous,  323;  rates  of,  333-35. 
See  Federal  Reserve  Banks. 

Reserve  clearing  system.  See  Checks. 

Reserve  funds,  used  for  speculative 
purposes,  15  n. 

Reserve    percentages,    225-27,    238. 

Reserve  ratio,  changes  in,  298,  320; 
as  a  guide  for  rediscount  policy, 
324-30;  should  be  made  more 
manageable,  342. 

Reserves,  of  member  banks,  222-24; 
percentages  for  reserve  and  mem- 
ber banks,  225-27;  gold,  227-30; 
to  be  held  entirely  with  reserve 
banks,  231,  232;  surplus  of  re- 
serve banks,  323. 

Reynolds,  Arthur,  246. 

Sectionalism,  and  the  regio.ial  plan, 

5,  8-14. 
Senatorial      Banking       Committee, 

240. 
Short-time    paper,    in    open-market 

operations,  190. 
Silver  dollars,   melting  down   of,   in 

accordance     with     I'iLtnian     Act, 

212-14. 
Single-name  and  double-name  paper, 

75-82,  108-11. 
Speculation,   reserve   funds  used   in, 

15  «.;  land,  133,   134,  151;  boom, 

315. 
Speculative  paper,  objections  to  re- 


discount  of,    72-75;   criterion  of, 

85-93. 

Sprague,  O.  M.  W.,  quoted,  80,  324. 

State  banks,  conditions  for  member- 
ship of,  in  the  Federal  Reserve 
System,  52,  53;  unwillingness  of, 
to  join  Federal  Reserve  System, 
54;  doubtful  legal  position  of,  55, 
56;  question  of  doutiie  liability  of, 
56;  on  rediscountability  of  paper 
held  by,  57-59;  other  reasons  for 
unwillingness,  59-64;  increased 
membership,  65-67;  considerations 
on  membership  of,  67-69. 

Stewart,  Walter  W.,  280. 

Stokes,  E.  C,  quoted,  310,  31 1. 

Strong,  Governor,  58,  219. 

Syndicate  acceptance,  175-80. 

Tcr  Meulcn,  180. 

Thralls,  Mr.,  quoted  on  the  Hard- 
wick  Amendment,  40. 

Timber,  86,  87. 

Time  items,  collection  department 
for,  44,  45. 

Tractor  paper,  138. 

Trade  acceptances,  operating  in 
same  manner  as  check,  109;  ad- 
vantages urged  in  behalf  of  en- 
couraging use  of,  111-14;  means 
employed  to  extend  use  of,  115; 
origin  as  distinct  class  of  commer- 
cial paper,  115;  qualifications  to 
which  it  must  conform,  115,  116; 
why  drawn  in  form  of  draft,  116; 
comparative  amount  of,  dis- 
counted, 117;  obstacles  in  the  way 
of  wide  extension  of  its  use,  Ii8- 
20;  aid  to,  justified,  120;  objec- 
tionable methods  of  using,  120- 
23;  in  renewals,  122;  on  strength 
of  firms  whose  allegiance  to,  was 
sought,  123,  124;  used  relatively 
infrc(|uently,  125;  limitations  re- 
garding amount  of,  125-27. 

Trade  credit,  historical  causes  of 
present  methods  of,  107. 

Trade  paper,  provisions  pertinent 
to,  no. 


352 


INDEX 


Treasury  certificates,  short-term,  is- 
sues of,  in  the  War,  267,  268;  short- 
time  fiscal  requirements  of,  300. 

Two-name  paper.  See  Double-name. 

Wages,  305. 

War,  the  Great,  effect  on  finances, 
240-42;  effect  of,  on  operations 
of  member  banks,  276,  277;  con- 
ditions following,  292-97. 

War  finance,  successful  and  unsuc- 
cessful, 284-91. 

Warburg,  Paul  M.,  65;  quoted  on 
trade  acceptances,  80,  81;  on  the 
contrast  between  European  and 
American  banking  methods,  107; 


on  trade  acceptances,  118,  119;  on 
quoting  forward  discount  rates, 
189;  on  the  storing  of  gold,  228;  his 
appointment  to  Federal  Reserve 
Board,  240. 

Warrants,  194,  250. 

Williams,  John  Skelton,  quoted  on 
speculative  use  of  reserve  funds,  15. 

Willis,  H.  P.,  quoted  on  central 
bank,  8. 

Wilson,  President,  240. 

Withers,  Hartley,  244. 

Youngman,  Anna,  her  objection  to 
open-market  operations,  196-200; 
on  rate  increases,  340. 


This  book  is  DUE  on  the  last  date  stamped  below 


FEB  2     1933 

APR  1  7  193, 


May  14  "SP 

ii    27  'oO"-  "  '■'' 

<f,    APR- 


l!i/4 


FEB    81988 


^? 


j*?;- 


d 


^m  8    19 


Dec  13 '5? 

Form  L-9-15)?(-7,'31 


UC  SOUTHERN  REGIONAL  LIBRARY  FACILITY 


AA    001  028  442    0 


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